LONDON - Britain's central bank resorted to buying bonds again on Wednesday in an emergency move to reduce the chaos in British financial markets that was triggered last week by the tax and spending plans of new British Prime Minister Liz Truss.
The slump in government bond prices - and the subsequent surge in yields - has threatened to wreak havoc in the country's pension industry, hurt the housing market and increase the recession risks for the broader economy.
Here is why the Bank of England (BOE) acted and its impact:
Why is Britain facing another financial crisis?
Investors were already worried about the huge cost of the tax cuts and energy subsidies promised by Ms Truss even before Finance Minister Kwasi Kwarteng announced more cuts to taxes last Friday.
Rather than heed Mr Kwarteng's promises of stronger economic growth, investors took fright at the prospect of higher inflation caused by the tax cuts, which they saw as forcing the BOE to speed up its interest rate increases.
The pound plunged, adding to inflation pressure in a country that relies on imports for its fuel, food and other products. Even more worryingly for the BOE, yields on government bonds leapt, especially on long-term debt, threatening to cause problems in Britain's pensions industry.
Why is the BOE buying bonds again?
By buying bonds, the central bank is seeking to reverse what it sees as "dysfunction" in the bond market. Specifically, it is seeking to address problems facing pension funds.
The funds are very sensitive to sudden drops in long-dated bond prices and in extreme market conditions, a vicious circle of forced sales and further price falls can set in.
By temporarily acting as a buyer for the bonds, the BOE aims to prevent panic selling.
But the buying programme is different to the one the BOE launched during the 2020 Covid-19 pandemic, after the Brexit referendum and following the 2008-2009 financial crisis, as it is only designed to be very short-term.
What can the UK government do now?
Ms Truss promised to smash the economic "orthodoxy" in her bid to become leader of the Conservative Party and Mr Kwarteng's tax cut announcements last week represented a doubling down on the pledges she made during her election campaign.
After the shock reaction of markets, some investors have said the only way the new government can regain their confidence is by reversing the tax cut plan, something Ms Truss and Mr Kwarteng have shown no sign of doing.
Instead, Downing Street says there will be more announcements of reforms to improve the growth potential of Britain's economy - which are likely to involve attempts at cutting back planning rules, changes to the immigration system and more investment in training and infrastructure.
What about the pound?
The currency whipsawed on Wednesday, jumping as high as US$1.09165 and falling as low as US$1.05390, before closing up about 1.5 per cent at US$1.0889.
On Thursday, the pound began falling again and was down 0.8 per cent to US$1.0799 at 2.54pm Singapore time.
This makes for a 4 per cent plunge in the pound since Friday (Sept 23) when the government announced the tax cuts and the biggest increase in borrowing since 1972. For the year to date, the pound is down about 20 per cent.
This means Britain will face more currency-induced inflation pressure than its European peers at a time when its inflation rate is the highest among the Group of Seven big economies. Investors are betting that the BOE will push up interest rates to almost 6 per cent by May, much higher than their current 2.25 per cent level.
Against the Singapore dollar, the pound rose to as high as 1.5625 on Wednesday, but dipped 0.34 per cent to 1.5572 on Thursday.
What does all this mean for the UK housing market?
Mortgage lenders have scrambled to keep up with wild swings in the sterling funding markets that determine what mortgage rates they offer to home owners.
Some lenders temporarily stopped issuing mortgages to new customers and others ramped up repayment rates for new loans to levels likely to stretch millions of existing home owners and make new mortgages unaffordable for many others.
Mortgage deals for new customers now feature rates of around 5 per cent to 6 per cent - a steep increase from the norm of around 2 per cent for the last five years that is prompting rising concern of a collapse in the property market further down the line. REUTERS