[ctrlmeta]

I asked this in a different post but did not get any answer, so asking it here hoping someone can help me understand this.

Can someone more financially literate than me explain how BoE buying government bonds is going to restore financial stability? Will it slow down the falling pound? Will it reduce inflation? What mechanisms are at work here?

[presioneaqui]

1) Pension funds (and other institutional investors) own government bonds. 2) They have also purchased risk/hedging products and posted these bonds as collateral. 3) As interest rates rise, the value of these bonds fall. 4) As the value of these bonds fall, these institutions are asked to post more collateral. 5) To come up with more collateral, they sell more of their bonds, dropping the price even more. 6) They are asked to post more collateral....death spiral.

The BoE buying these bonds applies the brakes on bond prices and "restores financial stability".

[mamonster]

This is the only correct answer I'm seeing so far here. Article clearly states BoE is avoiding rolling margin calls that could get triggered this week. Right now it is all about bailing out pension funds.

One other note: They could also be holding these bonds themselves on leverage. They could be asked to post cash as collateral for these bonds(which are now essentially risky assets).

[than3]

They were always risky assets the moment they started QE.

The main problem, its now almost impossible to avoid extreme hyper-inflation (which inevitably will cause a repeat event but much worse) and when the mechanics force it back there will be a deflationary cycle (that feeds on itself).

There have been a lot of policy mistakes over the past two years. Selling more bonds in an environment of rising interest rates is what a fool would do.

[ctrlmeta]

> 4) As the value of these bonds fall, these institutions are asked to post more collateral.

Why do the pension funds (and other institutional investors) need to post collateral? Where do the pension funds post their collateral to?

I guess I will understand why collateral is required if you can explain me what would go wrong if the pension funds were not made to post collateral.

[presioneaqui]

Fundamentally, pensions are a FUTURE liability on CURRENT assets. So the primary goal of the fund managers at these pension funds is to ensure that size and mix of current assets can meet future liabilities. One of the biggest risks to this objective is inflation which will eat away at the value of current assets. To hedge against this risk, a fund may purchase inflation/interest rate risk protection (usually complex swap products from derivatives desks at big banks) and pay for this protection with some combination of cash or collateral.

Now it looks like while these products work in a low interest rate - low inflation environment, in this environment this "protection" is pretty worthless at best and actually harmful even.

That's why the current UK gov is under fire, because their tax-cut proposal has been perceived to have precipitated this crisis.

[JumpCrisscross]

> why collateral is required if you can explain me what would go wrong if the pension funds were not made to post collateral

They're trading something everyone has to post collateral (a/k/a margin) on. This usually involves leverage, e.g. if they're buying futures [1].

The collateral is there for the broker and clearinghouse to sell if the pension fails to hold up its end of the deal. When the value of the collateral falls, the broker demands more to ensure they're covered.

[1] https://www.cmegroup.com/education/courses/introduction-to-f...

[mamonster]

Big banks. A bank lending any sort of investment vehicle money to essentially purchase assets on leverage is called a prime broker.

[mamonster]

They need to post collateral because they have leverage. And they need to have leverage because secure products like bonds don't earn a big enough return to meet pensions obligations. Yields were below 5% for the past I don't know how many years.

[naveen99]

government bonds are used for collateral allowing banks to go 10-20x leverage. When some of those 10 year bonds lose 25-50% of their value, banks get in big trouble. I bet pension funds are a small part of the problem but are being used to save face of the banks, money market funds, and other dealers of bonds.

[ivanjermakov]

Purchasing bonds (increasing demand demand) makes bond yield lower. Lower the yield - less government has to pay for debt servcie[1].

[1]: https://www.investopedia.com/terms/d/debtservice.asp

[dragontamer]

> Will it reduce inflation?

No. Apparently the BoE is worried about other things right now, rather than inflation.

Which sounds pretty bad, because it seemed like inflation should be the #1 concern right now. But BoE has other economic data and are clearly worried about something else...

> Can someone more financially literate than me explain how BoE buying government bonds is going to restore financial stability?

Nominally, you'd do this if you were worried about deflation. I don't know what kind of economic data suggests deflation right now though...

[Veliladon]

> Which sounds pretty bad, because it seemed like inflation should be the #1 concern right now. But BoE has other economic data and are clearly worried about something else...

Like some clod announcing they're going to decimate revenue by cutting taxes for their rich mates and plug the hole by massively increasing borrowing?

[bko]

The banks and pension funds hold the assets. BoE will now buy these assets, driving up the price and helping the banks out (recapitalizing them).

This is the opposite of what you would do if you want to reduce inflation. You're inserting more money into the system and removing IOUs (debt). Originally BoE was concerned about inflation but now they're moving against what they deem a bigger threat, big banks and pension funds are in financial trouble

[cjrp]

My basic understanding is it will reduce the current price of government borrowing. Also they were concerned that existing gilts held by pension firms would be so devalued that they’d trigger some kind of mandatory sell-off (with the associated negative effects on the rest of the market).

[yuan43]

It's a move designed to affect market psychology mainly. Multiple central banks have concluded that QE at best contributes marginally to the reduction of long term interest rates. People want something to be done, and BoE delivers.

It also shifts the discussion from "what's causing the fall of the pound and the rise of long term rates" to "what will be the effect of this new round of QE?"

To get a better picture, take a broader view. This move comes as all of the world's currencies are falling against the dollar. Why?

This article might be helpful:

https://www.lynalden.com/global-dollar-short-squeeze/

[ctrlmeta]

Can you explain what QE is and how long term rates are connected? Do you mean that the fall of pound is inevitably going to require UK banks to increase interest rates to make pound more attractive to investors?

And what's the problem with increasing interest rates? Is it that rising interest rates makes new businesses difficult to borrow money? And difficulty in borrowing money leads to shrinking economy?

[bko]

Interest rates are the price of money. Its how much you have to pay to borrow money. If there is a lot of money in the system, interest rates are low, and vice versa.

Interest rates are also inversely correlated with price. For instance, if I buy a bond that pays 5% for $100 and tomorrow someone can lend money at 6%, no one is going to pay $100 for a bond that's paying only 5%. If they can lend money now only at 4%, they'd pay over $100 for the bond paying 5%.

BoE is going to be buying a lot of bonds, which means the price is going up (increase in demand) and others will pile in. And since price and interest rate are inversely correlated, that means yields (interest rates) are going down.

Similarly if interest rates go up, the bonds that banks and pension funds hold will go down in price (inversely correlated). But the downside is there's more money in the system, cheaper credit, more inflation and decrease the valuation of the currency relative to other currencies.

[than3]

Historically, interest rates must rise to the same rate of inflation to reduce inflation.

If they don't rise fast enough you get stagflation where businesses not willing to shoulder the cost of governmental mistakes reduce their production and lay people off creating high unemployment in an inflationary environment. This however, is only a brief stay before deflationary forces put you into a deflation death-spiral.

Failing to raise interest rates, and increasing paper printing creates hyper-inflation. As the currency debases, costs rise in a cost-push inflation environment (starting at the producer level), and inevitably the division of labor breaks down with social unrest (Zimbabwe, Weimar).

Ray Dalio has published a book series on how historically these debt crises play out. Its been fairly accurate. Its a normal cycle, usually happening towards 100 years after a fiat currency is adopted, though that timetable can be faster with malfeasance and fraud.

[than3]

From what I saw, the dollar was significantly gaining on the pound. It could potentially slow down the pound in the interim. It will most definitely increase inflation further at a time of stagflation.

They probably justified that they had to do it because once you get into a deflationary cycle it feeds on itself. There have already been a number of policy mistakes worldwide (ECB did the same thing early on). This is just a drop in the bucket.

[kennethh]

This is basically QE, the Bank of England is printing money to buy the long duration bonds since no one else will buy them due to expectations of rate increases. Check out 30 years US bond TLT, https://finance.yahoo.com/quote/TLT?p=TLT&.tsrc=fin-srch which have gone from 150 to 100 in one year.

[dannyw]

Or TMF, which has gone from 26 to 8.

[boppo1]

Someone correct me if I'm wrong[3]:

1. Buying bonds pushes the price of bonds up (pretty basic, right?)

2. Bonds have a constant interest payment, so if you buy a higher priced bond, the size of that return as a % of what you paid (yield) is smaller.

3. When you evaluate risky[0] securities (company stocks and bonds) or other risky financial investments, you compare them with something risk-free[1] like government bonds.

4. More specifically, to determine how much something is worth now, you calculate Net Present Value (NPV) using the Discounted Cash Flow (DCF) method. This is the method that all serious financial companies employ[2] on some level to determine the prices of things.

5. NPV is the sum of each (future cash flow / (1 + discount rate)^t) where t=compounding periods (typically years) and the discount rate is the benchmark rate that you're comparing to.

6. Hence, if you are using government bond yields as the discount rate in your calculation, if the yield goes down, your NPV goes up. So by lowering government bond yields, you help support the price of financial assets.

7. If you are not familiar with finance, you may be inclined to ask "hold on that seems like it supports stock prices not the actual economy" "what about the value of money?" "what about the quality of activity being supported?" "once you start, how do you stop?". Interfering with the 'natural' rate of interest on benchmark securities was and remains a hotly contested topic, however it has been accepted as a status quo method in western economies that feature a central bank.

[0] not risky as in Gamestop, but risky as in 'any investment that could possibly go badly'

[1] We generally treat US treasuries, and sovereign debt for stable countries like the UK and Germany as 'risk-free'. If these borrowers ever default, we probably have bigger problems to deal with than the valuation of Coca-Cola.

[2] Lots of valuations are not calculated using DCF, companies often just use comparables and 'multiples' (literally just value something by saying it's "10x earnings/ebitda (current period cash flow)". However, this is mostly just companies that need to make lots of valuation calls very quickly and off-the-cuff. Generally speaking DCF is the 'fundamental theory' of valuation, and then other more or less complex models are built off of its ideas. I.E. adding coefficients of probabilities, what-if scenarios, etc to future cash flows.

[3] which is possible given I'm laughably unemployed

[chromatin]

They are protecting bonds (by propping up their price) in an effort to save pension funds; all at the expense of their currency.