Tommy Wilkes and Saikat Chatterjee

LONDON, (Reuters) – As the Bank of England made its Nov. 4 policy announcement, some London traders heard gasps.

Many traders, investors and banks believed that the Governor Andrew Bailey, Chief Economist Huw Pil, had indicated interest rates would rise in order to combat inflation.

The British central bank instead kept the borrowing rates unchanged, with Bailey and Pill voting against any increase.

Two London-based senior traders said that those who were caught lost their money.

The head of UK rates trading at major European banks said that “a few four letter words” were spoken. This was because he wanted to keep his comments private about the central banking.

    The BoE declined to comment. Bailey and Pill were not available for comment because the bank was still in quiet mode before its Monetary Policy Committee announcement Thursday.

Bailey had previously stated that the communication by the bank was valid. He said that an November rate increase was cleary not possible and that policymakers were not responsible for assisting traders.

    But conditions in the market for UK government bonds, known as gilts, have broadly deteriorated since that Nov. 4 surprise.

Peter Chatwell from Mizuho London, who heads multi-asset strategy said that “the main problem is that market participants do not understand the BoE’s reaction function” Markets will continue to trade in uncertainty until that confidence is restored.

The traders stated that liquidity, which refers to the ease of buying or selling a bond, is more difficult in gilts now than it was in large government bond markets. However investors are reluctant to accept new positions regarding rate direction.

According to Refinitiv data, the difference in the selling price for a 2-year gilt and the purchase price by a buyer, known as the bid-ask spread has increased more than the historical average. Market participants claimed that recent British debt auctions have seen less investor interest.

    A review by Reuters of the order book of a U.S. bank in London showed its traders cut the amount of gilts they were willing to trade in the days after the meeting, reducing liquidity provided to the market.

The bank charged nearly twice the price to trade a $1,000,000 gilts transaction.

BALANCING AGENCY

For central banks to be able communicate with investors effectively, they need markets that are efficient in order to attain policy objectives like controlling inflation or guaranteeing jobs.

Current attempts to reduce the need for life-support during pandemics and tackle high inflation are making this task more challenging. Low-risk, easy to trade government bonds form the basis of many portfolios. Investors are now having difficulty understanding the meaning of each pronouncement.

Recent revelations by U.S. policymakers revealed that they used the term ‘transitory,’ in an attempt to explain a price rise. In November, Australia’s central banks shocked the markets by lowering its bond yield goal.

The BoE was misinterpreting the BoE’s message when Bailey, a member of a panel, stated that it had signalled that “we will need to act” in order to combat inflationary pressures.

    A day later, Refinitiv data shows, markets were pricing in a 100% probability of a 15 basis point rate rise in November, up from 40% before Bailey’s comments.

U.S. Commodity Futures Trading Commission data show that after Bailey spoke, hedge funds placed a net $1B wager on the British pound falling into a $1.3B bet it would rise. The position was reversed again on Nov. 4 when they bet $2.9 billion that the pound would fall.

    Speaking immediately after the rate announcement, Bailey said he had been clear that his comments were conditional on the bank seeing inflation expectations rise. Bailey also referred to the polls showing that economists predicted that the BoE wouldn’t raise rates.

    “I never said, none of my colleagues ever said, you know, ‘Rates will go up in November,'” Bailey said.

A trader stated that they had mistakenly taken Bailey’s view as representing the majority of nine rate-setters at the bank, and not his. BoE governors usually vote for the majority.

The expectations of a BoE rate increase in February have been rescinded by the money markets.

    MARKET RILED  

    While government bond markets have been hit by worries about inflation and the Omicron COVID-19 variant, heightening volatility, traders say gilts have displayed signs of particular stress since Nov. 4.

According to Tradeweb, the bid-ask yield differential for a 2-year bond increased by more than half to 3.1 basis point on Tuesday. It has been above its 2021 average value of 1.6bps since then.

    By one measure, that spread exceeds those for comparable Italian and Spanish government bonds, which are considered more volatile and risky than gilts.

Head of UK Rates at the European Bank stated that end-clients are receiving bid-ask spreads up to three times higher than usual for UK bonds, which makes it more expensive to trade.

     Volatility, a measure of price moves, hit its highest on record for three-month British debt in mid-November, Refinitiv data shows.

    The disruption may have affected debt sales, too.

Since Nov. 16, three bond auctions have had yield tails of at least 1 basis point. This suggests that Britain’s Debt Management Office needed to take lower bids in order to maintain healthy bid-cover ratios. In March 2020, markets were roiled by the COVID-19 pandemic.

DMO did not respond to our request for comment.

April LaRusse of Insight Investment is a specialist in fixed income. Previous stressors such as the Brexit vote caused similar disruptions. Investors expect an end in easy monetary policies.

She stated, “The market has become twitchy and there is confusion in the messaging of the BoE.”

Losing Confidence https://graphics.reuters.com/BONDS-SPREADS/gdpzymjglvw/chart.png