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Guilty as charged

by henrycopeland
Wednesday, May 13th, 2009


The BoE has made clear one of its main objectives in buying £125 billion ($189 billion) of gilts is to drive down gilt yields. In theory, this should be impossible since, as senior Bank officials admit, the gilt market is extremely liquid and deviations in yields away from market interest rate expectations should be quickly arbitraged away.

But these are not normal times. The U.K. government’s decision to borrow 220 billion pounds this year and £600 billion over the next five years means gilts yields have been well above levels implied by the swaps market. Without quantitative easing, gilt yields would be much higher.

In fact, the BoE’s efforts to manipulate the gilt markets may actually be exacerbating the problem. Credit market participants are increasingly uncertain about the true risk-free rate and the market’s interest rate expectations. That makes it harder to price assets — and may drive yields higher even as the BoE is trying to drive them lower though quantitative easing.

In an ideal world, a strong independent central bank would tell the government to get a grip on its borrowing, rather than mopping it up. Instead, the U.K. financial framework requires the BoE to accommodate itself to the government’s reckless fiscal policy. The weakness will eventually have to be addressed — but it might take a crisis to get there.

Same goes for the Fed.

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