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Wednesday, March 25, 2009


british gilt auction failure

german bund auctions have regularly been failing to cover for some time. that has been excused, perhaps correctly, by the vagaries of the auction method used by the german government.

that rationale does not apply to the united kingdom, however, and the british today experienced their first failed gilt auction of the downturn. previous fails occured only in inflation-linked bonds; this is a different story, and perhaps the first failed auction on record for british gilts.

Investors bid for 1.63 billion pounds ($2.4 billion) of the 40-year securities, less than the 1.75 billion pounds of 4.25 percent notes slated for sale, the U.K. Debt Management Office said today in a statement from London.

“Basically it’s the first failed auction,” said John Wraith, head of sterling interest-rate strategy at RBC Capital Markets in London. “They didn’t receive enough to cover it all so the market has obviously sold off extremely heavily.”

The yield on the 10-year gilt jumped 10 basis points to 3.43 percent by 11:45 a.m. in London. The 4.5 percent security due March 2019 slipped 0.84, or 8.4 pounds per 1,000-pound face amount, to 109.02. The yield on the two-year note rose six basis points to 1.30 percent. Yields move inversely to bond prices.

Prime Minister Gordon Brown’s government plans to sell an unprecedented 146.4 billion pounds of debt this fiscal year as Europe’s second-largest economy grapples with its first recession since 1991. Demand hasn’t fallen short at a sale of regular U.K. government bonds since 1995.

The U.K. had two failed auctions in the past 10 years, the most recent in September 2002 when the Treasury received bids for 95 percent of the 900 million pounds of 30-year inflation- protected bonds offered, according to the DMO’s Web site. The other failure was in 1999, when it tried to sell 500 million pounds of inflation-protected bonds.

“The risk of uncovered auctions is a normal part of the process,” said Sarah Ellis, a spokeswoman for the DMO in London. “Today’s auction was at the riskiest part of the curve. An additional factor which may have deterred some bidders is the imminent end of the financial year.”

perhaps BoE will now try to execute quantitative easing with some greater competence. macro man:

... [I]n the UK, the impact of QE was dulled yesterday by a higher-than-expected inflation print (the joys of a weak currency!) and comments from Merv the Swerve. Less than three weeks into QE, and Merv was already talking about the possible need to hike rates aggressively at some point. He also suggested that the BOE might not deploy its fully allotted £150 billion of buybacks should the program prove effective. While there was nothing technically wrong with these comments, they were the wrong thing to say to a teetering Gilt market, and were received with all the pleasure of a swift kick to the groin from an iron-tipped boot. Like Treasuries, Gilts are now below the closing on the day of the QE announcement. ...

In its most basic form, monetary policy is meant to influence the behaviour of economic actors. Virtually nobody outside of a few banks transact at central bank policy rates. But central banks change those rates in an attempt to influence other, market-based rates which do have a meaningful economic impact-bond yields, mortgage rates, etc. In a very real sense, while central banks adjust the sign posts, financial markets do the real work in changing monetary policy by moving market rates.

And yet when it comes to QE, Macro Man is hearing things like "the SNB wants to shake out a few longs before intervening again." What possible purpose does it serve to "punish" the very people who are supposed to make the policy work? While the SNB may be throwing a bone to the ECB by declaring that they don't actually want a weaker currency, it seems pretty clear that they do. Yet by submarining the market's positions, the SNB is creating a situation wherein any further intervention could be met with selling from relieved longs, rather than the sort of coat-tailing that would put EUR/CHF back to where it was a few months ago. Similarly, one wonders why the Fed would introduce unnecessary volatility in the back end of the yield curve by misleading the market with its statement a week ago.

To be clear, Macro Man is not asking for a handout or a tip-off, nor does he require one to make money these days a la Bill Gross. But by the same token, central banks should realize that the market is their ally in QE, not their enemy. Clear, unswerving policy and a total public commitment to maintain it (even if you don't actually mean it) will render maximum effectiveness unto QE. Ambiguity and flip-flopping will put the relevant asset prices right back where they started, with the market further out of pocket, and the "nuclear option" exhausted and ineffective. Granted, that's been the inevitable outcome of all previous policy initiatives since the crisis started. But it would be a pity to see a shock and awful outcome for the last policy bullet in the gun.

britain is potentially running up against some very significant constraints to its fiscal policy construct.

in a balance sheet recession, private parties will be redirecting income and even savings to the retirement of debt and contraction of money supply as they repair their balance sheets. it falls to government to dredge those savings out of the banks and spend them via deficit-financed fiscal stimulus in an effort to manage aggregate demand and prevent the asset shock from propagating into a disastrous economic collapse. if the government sticks just to recycling the domestic cash being directed to banks, some contraction is inevitable to the extent that the good old days were characterized by foreign investment inflows and the importation of overseas capacity to fill excess demand. but just selling treasury debt in the amounts domestic savers can finance should be enough to forestall a heinous depression.

here, however, is where bank bailouts come in. these transfers are not stimulative spending, but rather essentially a straight debt swap from banks to government. they do require government debt to be increased -- as per the TARP, or the imminent losses to be shunted onto the FDIC by geithner's PPIP -- and in a closed economy that would mean less domestic savings available to fight demand destruction. meanwhile, the newly-repaired banks are basically powerless to promote spending as they have little loan demand to fill. the result would be an inability of government to fill the demand gap, resulting in more intense debt destruction and -- of course -- greater impairment for the banks to overcome.

countries like the united states and great britain are not, of course, closed economies. but they are more closed than they were a year ago as globalization is thrown for a loss, and it seems very likely that the slowdown of international flows will be persistent and even intensify. that will necessarily make it harder to sell government debt overseas. furthermore, in a competition between governments to sell their obligations, some will be losers -- and here britain may be one of them. faced with banking system losses that the sovereign cannot hope to backstop in full, it seems madness for the british government -- already subject to massive short-term foreign debt holdings vulnerable to roll risk -- to attempt to sell the kind of government debt it would take to continue to repair disaster banks like RBS, regardless of their systemic importance.

here quantitative easing, providing a potentially infinite sink for government bonds in exchange for newly created high-powered money, has thusfar stepped into the breach in britain, switzerland, the united states (beginning today) and elsewhere. central banks can grow their balance sheets by issuing cash to buy sovereign debt. the cash -- in an environment of low loan demand -- will preponderantly find its way to excess reserves, further ballooning the central bank.

i would have to think that the initiation by the BoE of quantitative easing just recently played a role here by overvaluing gilts, holding yields unnaturally low and creating an incentive to sell. some have forecast that QE could in some situations ruin the private bid and result in central banks owning most or all sovereign debt.

but this interplay of treasury and central bank is of course a manner of confidence game. while international confidence remains, loan demand is low, interest rates are near zero, credit creation is negative and inflation is only what fiscal stimulus allows, there is little chance of an inflationary runaway.

but should international confidence break and a run on the debt and currency of the sovereign be enjoined -- perhaps as a result of attempts to sell much more government debt than can be absorbed without massive concessions to the market -- there exists the potential for an icelandic outcome.

UPDATE: bloomberg's second update includes some even more harrowing quotes.

“This is a warning signal investors are sending to the government,” said Neil Mackinnon, chief economist at hedge fund ECU Group Plc in London, who helps manage about $1 billion in assets and is a former U.K. Treasury official. “Investors are giving the thumbs down to the gilt market.”

“This sinks Brown below the waterline,” said Bill Jones, professor of politics at Liverpool Hope University. Brown’s “whole strategy is based on borrowing and now he can’t get anyone to buy his gilts. This means the prospect of going cap in hand to the IMF hovers increasingly into view.”

the UK was previously bailed out by the IMF in 1976.

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