All eyes have been on the UK economy since Kwasi Kwarteng delivered his mini budget on 23 September. The Chancellor of the Exchequer’s huge tax cutting exercise, coupled with a lack of measures to raise additional income for the public purse, spooked markets.
It sent the value of the pound tumbling to record lows compared to the US dollar, and led to warnings from the Bank of England that significant interest rate hikes are likely - something that has pushed up mortgage rates across the board.
The news that the government would be embarking on a huge borrowing programme also created turmoil, as it nearly led to a run on pension funds - financial institutions who tend to invest heavily in the usually stable government debt market.
In a bid to stabilise the situation, the Bank of England launched a major bond buying exercise. The Chancellor Kwasi Kwarteng has also sought to calm the markets by u-turning on when he will give a fiscal statement detailing the government’s longer-term plans for the national debt. It is excpected that he will have to announce major cuts in public spending, with respected think thank the Institute for Fiscal Studies (IFS) warning he needs to find £60 billion from such cuts.
So what are gilts - and how has the UK central bank intervened this week? Here’s what you need to know.
What are gilts?
Gilts, usually known as bonds, are vehicles for borrowing money. They are essentially debt in the form of a product that can be bought up by a third party in exchange for a particular return over a set period of years or decades. Investors typically get their money back, plus interest.
While bonds can be issued by private sector companies, the term ‘gilts’ is specifically attached to government borrowing.
The reason why probably stems from the term the word derives from - ‘geld’. In Anglo-Saxon and then Norman times, geld was a tax paid to England’s kings and queens. Another type of geld - ‘Danegeld’ - was used to pay off Danish invaders in the late 10th and early 11th centuries.
Geld morphed into ‘gilt’ at some point in the 1300s, with the newer term referring to gold or money. The modern meaning of the term came into being during the reign of William III - or William of Orange (1689 to 1702).
Merchants who ran some of the UK’s first-ever companies loaned the government money to finance the country’s war with France. They did so through the Bank of England, which had been founded to bank for the government in 1694. This arrangement saw these early investors paid back via specific taxation.
Over the years, this system has evolved so that those providing these loans can make a particular amount of money off them in the form of interest.
Gilts are usually considered to be a low-risk form of investment because they are long-term commitments and come from the government, which can never truly go bust.
The government has also historically not issued vast quantities of them all at once with no longer-term financial plan or independent forecast - until Kwasi Kwarteng became Chancellor at least. This has meant that the value of gilts has rarely changed at a rapid pace.
What is the Bank of England bonds intervention?
The Bank of England’s primary roles are to keep the value pound sterling stable and ensure the UK economy remains on an even keel. Essentially, it safeguards our purchasing power and makes sure our money is protected when we invest or save it.
When Kwasi Kwarteng’s £45 billion in tax cuts and the hefty bill for Liz Truss’s energy price guarantee were announced, it led the markets to believe that the government was about to launch a major public borrowing exercise. The lack of an Office for Budget Responsibility (OBR) forecast and a longer-term government spending plan, as well as a promise from the Chancellor that more tax cuts were coming, also led to market concern about further unfunded borrowing down the line.
It brought about a major fall in value for government gilts while investors demanded bigger returns for what they felt had become a riskier investment. It meant that pension funds, which buy up and trade a significant amount of government bonds, were suddenly at risk of going under, while the cost of government borrowing was set to soar.
The situation forced the Bank of England to intervene as it said there was a “material risk to UK financial stability” because it could lead to “a reduction of the flow of credit to the real economy”. Essentially, the general public’s money and businesses were at risk.
The UK’s central bank announced it would buy up £65 billion of government bonds between 28 September and 14 October in a bid to stabilise the market. But with this deadline looming and no economic plan due from the Chancellor until the end of the month, investor concerns were threatening to create fresh market turmoil.
Indeed, pension bosses said they were keen for the central bank’s support to be extended until Mr Kwarteng’s next statement, warning the package was ending “too soon”. But this request was denied by Bank of England governor Andrew Bailey. His reiteration of the 14 October deadline sent the value of the pound tumbling yet again - it fell 0.85% to $1.099, which is the lowest its been since 29 September.
On Monday (10 October), the Bank of England doubled its daily bond-buying limit to £10 billion. On Tuesday (11 October) it then followed up this exercise with an expansion of the kind of gilts it was buying up - adding index-linked gilts to its emergency package.
The Bank of England said this action was necessary to avoid a “fire sale” (i.e. rapid sell off) of government bonds and “to restore orderly market conditions”. It came after longer-term bond yields - the returns demanded by investors for buying up decades-long government gilts - rocketed on Monday.
While the move has calmed markets - for now, at least - commentators said the central bank’s actions suggested it was still in firefighting mode, rather than in control of the situation. Neil Wilson, chief market analyst at Markets.com, said the Bank’s third intervention “seems rather messy and panicky”.
He said: “As expected the market was always going to retest the Bank’s resolve and put the budget to the sword. To expand your emergency intervention in the market once is unfortunate, to do so twice looks like carelessness.”