Why Is the Bank of England Paying Premiums?

Perhaps a better question is, why are Bloomberg and others calling them “premiums” and fretting about this?  The Bank of England’s new quantitative easing (QE) program to combat the negative economic consequences of Brexit means there is an extra $1.5 billion of sovereign bond demand a week.

BOE purchase premiums

Granted, we should expect that increase in demand to have been priced into market rates at the time the new QE program was first announced, not at the time of execution of the actual purchases.  Perhaps concerns over the credibility of the program due to the BOE’s failure to hit its sovereign bond purchase targets in the first week of the new program left yields higher than they otherwise would have been.  Or, perhaps the BOE is running up against sellers that are more price-inelastic than market players had anticipated.

To be fair, Bloomberg followed their article on the BOE paying premiums, with one saying that maybe it’s not so bad after all as higher bond prices will push down yields further.

And that’s exactly right.  As the BOE soaks up more and more UK sovereign debt, it will face buyers such as pension funds that are increasingly price inelastic as they seek to match their long-term obligations with long-term assets.  This inflection point, if not properly anticipated (and thus, priced in) by market players, means prices will jump more and yields will fall even further.

Not only that, but these price-inelastic investors are also likely to be more segmented from the rest of the market.  That is, they’ll likely reinvest in long-term assets despite increasingly negative term premiums as they attempt to match their assets and liabilities.  Given that these funds are also under pressure to produce sufficient returns, they should increasingly turn to funding riskier and/or real long-term investments such as infrastructure or corporate debt.   This increase in risk appetite and real investment would be another success for the BOE and in line with its goals for QE.

The Bank of England isn’t paying “premiums.”  It’s paying the market price that it is intentionally setting.  Price jumps as the BOE executes its QE purchase do not signal a threat to the Bank’s effectiveness, but rather are an indication of its success.

 

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