Yesterday’s Fortune & Freedom introduced you to some of the chaos unfolding at the Bank of England. But all that was mere amusement compared to the huge problem we’ll look at today.
In fact, things are so bad at the Bank of England that they’re going to need a government bailout!
And this will make things so bad at the Treasury that it’ll need a bailout too. From the Bank of England, ironically enough.
Even more ironic is that the Bank of England is in such dire straits in the first place because it bailed out the Treasury in 2008 and 2020.
Have I lost you yet? Don’t let the confusion blind you to underlying the debacle. The Bank of England and the government are going down together in a blaze of bailouts.
This is quite an achievement, especially on the Bank of England’s part. To need a government bailout when you’ve got an infinite budget and can print money takes some doing.
I suppose that’s what you get for investing your infinite funds in the government’s bonds. It’s asking for trouble.
Then again, it was the government’s need of a bailout from the Bank of England in 2008 and 2020 which caused the vast pile up of bonds on the Bank of England’s balance sheet in the first place. And it’s those bonds which are the source of the trouble now.
So, perhaps it’s time to return the favour…
The only problem is that this has set up a truly bizarre and vicious circle which beggars belief.
But let’s try and untangle the mess, because it hints at a self-enforcing downward spiral to come at both the Bank of England’s and the Treasury’s finances.
Under the Bank of England’s quantitative easing (QE) programme, it bought a lot of government bonds. These bonds have market prices, which rise and fall. Well, fall and fall, of late. That’s because higher interest rates mean lower bond prices, and higher interest rates are very much on the cards.
If this combination of higher interest rates and lower bond prices is confusing, think in terms of shares and dividends. A £1 dividend on a share price of £10 gives you a yield of 10%.
If the share price rises to £20, but the dividend remains the same, the dividend yield for new investors is now just 5%. If the share price falls to £5, but the dividend remains the same, the dividend yield is now 20%.
So, yields and prices are inversely related – which means that they move in opposite directions.
Higher share prices mean lower dividend yields and lower prices mean higher yields for new investors in shares. It’s the same for bonds, which pay a fixed dividend known as a coupon.
As prices go up, returns for new investors fall. £1 in coupons on a £10 bond is a 10% yield, but only a 5% yield on a £20 bond.
And as prices fall, returns on offer for investors rise.
The confusing part is that the central bank heavily impacts, or even outright controls, the yields on some bonds by way of controlling interest rates.
As the central banks move the yields up and down by raising or lowering interest rates, this in turn moves bond prices.
Let’s return to dividends and stocks again to explain. If the government were to declare that all dividend yields on stocks must be 5%, stock prices would have to rise or fall to deliver those dividend yields.
In the same way, if (when) the Bank of England raises interest rates, bond prices must fall to offer the higher returns to new investors.
Those are the basics. Here’s the intriguing bit, which makes the UK unique, as far as I know.
Under the QE programme, the Bank of England got an indemnity from the Treasury for any losses on the QE programme. This means that, if the Bank loses money, the government must make good by sending it cash.
Those losses can happen in two ways. The first is an in-flow, out-flow problem.
The bonds the Bank of England bought have a yield which earns the Bank money. But the Bank of England also pays out interest to banks which keep money at the central bank, which is known as “Bank Reserves”.
As the Bank of England raises interest rates, the bonds it bought don’t pay more because they are like fixed-rate mortgages. But the interest paid to banks on reserves does rise with interest rates.
And so, if interest rates go high enough, the Bank will make a loss as the interest it pays out to banks is greater than the income earned on holding its government bonds.
And we’re not talking small amounts, either. The Office for Budget Responsibility suggests payments of £400 million in 2023-2024. And that’s just for starters. It could be £2.6 billion the next year – more than 0.1% of current GDP!
But those losses are only on the difference between what the Bank of England makes from holding government bonds and what it pays out to the banking system on the reserves.
The real losses will come as the Bank of England begins to sell government bonds as it reverses QE. This is expected to begin when interest rates are at 1%, but we’ll get back to that.
So far, the QE program has already realised losses of about £28 billion pounds for the Bank of England as bonds matured (the loan was repaid by the government) since 2013.
But actually selling the bonds at market prices will only dramatically increase these losses because the bonds must be sold at market prices. And those have been plunging since the Bank of England bought them, and will continue to plunge as interest rates rise.
Bloomberg reported on this back in February, with the headline “A £3 Billion Loss at the Bank of England Will Soon Be Rishi Sunak’s Problem”:
The BOE decision this month to begin unwinding its 895 billion-pound bond stockpile kicked off a process that will see gilt holdings fall by more than 200 billion pounds by the end of 2025.
The issue is that the price paid on most of those securities was well above face value, leaving the central bank in the red once they mature or are sold. Under a government indemnity with the BOE, the state must make good the difference. The shortfall for the total QE holdings amounts to about 115 billion pounds.
Now we’re talking real money! About a sixth of the UK government’s total tax revenue!
But let’s quickly review to keep things clear. As the Bank of England raises interest rates, reducing the prices of bonds it bought under QE, it incurs losses on those bonds if it tries to sell them. And the government must refund those losses to the Bank of England under the indemnity agreed to.
With interest rates much higher than under the QE period, bond prices have already fallen. And the Bank of England will soon be booking a loss as it executes its planned quantitative tightening (QT) which means selling the bonds it bought under QE.
If all this sounds wacky, and it is, here’s Bloomberg’s version of events to come:
The UK Treasury will make payments to the Bank of England for the first time to cover losses from the institution’s quantitative easing plan, according to the nation’s fiscal watchdog.
The forecasts, if realized, would mark a historic moment for the UK and may prove politically tricky for the Treasury. It could force the government to either earmark future taxpayer funds away from other projects to compensate the central bank or increase borrowing to cover the cost.
And the chancellor has already pledged that “any potential future cash shortfalls will be met in full [by you, the taxpayer].”
No wonder his wife went for non-dom status! Who would want to be on the hook for the Bank of England’s vast losses?
Another startling factor is that this reverses what had been a free fiscal tailwind for the government. Profits made by the Bank of England had been flowing into the Treasury, boosting the government’s coffers. We’re talking about £120 billion over the past 13 years.
But that could soon become a whopping loss as QE is reversed. So it’s not just about losing money, but reversing a flow from going into the Treasury to out of it.
But wait, there’s more.
The Bank of England is discovering, much to its surprise (but no one else’s) that selling a face-melting amount of bonds after bidding up their price to eye-watering levels is easier said than done… without crashing the price of those bonds and dramatically increasing losses above the already sweaty-palm-inducing estimates.
If this reminds you of the incredible stupidity of Gordon Brown when he announced to the market that he’d be selling a lot of the government’s gold, you’re on the right track.
The gold price crashed on Brown’s announcement, and you’ll never guess what happened to bond prices when the Bank of England announced its plans to sell its bonds under QT…
Bloomberg observed on 25 April:
Poor market conditions are giving the Bank of England a reason to refrain from actively reducing its 847 billion pound ($1.1 trillion) gilt portfolio as soon as next month.
The market just won’t bear the huge volume the Bank of England is planning to dump into it.
Analysts at ING have penned a report called, “Why markets aren’t ready for the Bank of England to start selling bonds.” And Governor Andrew Bailey said last week the institution won’t sell into “fragile markets.”
The problem is, markets are fragile in the first place because of the Bank of England’s plans to sell the bonds. And because of the inflation that is running riot because the Bank of England hasn’t sold its QE accumulation of bonds yet.
In other words, the Bank of England is struggling to reverse QE with QT because nobody wants to buy bonds when the biggest buyer starts to sell its vast holdings.
Of course, it’s almost always possible to sell government bonds. What we’re really talking about, though, is the price.
But the Bank of England doesn’t want to crash the price as it sells its bonds. This is not just because this raises the losses it will incur itself, and thereby increase the size of the bailout it’ll need from the government under the indemnity. A crashing bond market also raises the government’s cost of borrowing too.
So, if the Bank of England triggers a bond crash, then the Treasury’s cost of borrowing will soar. As will the size of the Bank of England’s bailout bill, for which the Treasury is on the hook and must borrow money to finance…
This is a quadruple whammy and a self-enforcing spiral of losses and financial trouble between the central bank and the government. Let’s review exactly how…
The Bank of England’s losses on bonds are covered by the Treasury. The Treasury’s borrowing costs are set in the bond market. The bond market is crashing because of the Bank of England’s planned bond sales.
The Bank of England’s losses are soaring as the bond market crashes. And, to finance the future bailout of the Bank of England, the Treasury will have to borrow at the higher interest rates because bonds crashed…
At the margin, here’s how it works. The more bonds crash, the more the Bank of England loses and the bigger the bailout it’ll need. But it’ll also raise the interest bill for the government when it borrows the money to bail out the Bank of England.
To sum up the past, present and future, you could put it like this. In the past, the Treasury needed a bailout from the bank of England in 2008 and 2020.
Now the Bank of England will need a bailout from the Treasury because of the losses it will incur on the bailout of 2008 and 2020.
And in the future, the Treasury will need a bailout from the Bank of England in order to finance a bailout of the Bank of England.
No wonder MNI reported that the government tried to keep the Bank of England’s indemnity a secret! It sets up a self-enforcing downward spiral in the balance sheets of the government and the central bank.
Now, all of this is very interesting. But consider that the same underlying losses will happen at other central banks around the world. But they do not, as far as I know, have the same indemnity as in the UK’s Bank of England.
So, what happens when central banks start selling their vast bond holdings at a loss? Will other central banks go bust altogether, instead of getting bailed out?
I don’t know. And we might never find out, because doing so could be just too disastrous.
What all this really amounts to is exposing just how difficult, or impossible, it will be to reverse all the inflationary policies since 2008. The list of unforeseen chaos from higher interest rates and the end or even reversal of QE is rising rapidly.
And the chances of abandoning tighter monetary policy and allowing inflation are rising even faster.
Editor, Fortune & Freedom