The failure yesterday of the DMO’s auction (pdf) of 4.25% 2049 gilts – bids fell 7% short of the £1.75bn offered – has led to some hysteria, such as some of the comments here.
I fear, however, that the truth is rather more mundane.

The thing is, gilts are in normal times near-substitutes for each other: 2049 stock is very similar to 2048 stock, which is similar to 2047 stock and so forth. However, quantitative easing has changed this.

The Bank will buy gilts (pdf) in the 5-25 year range. Ceteris paribus, this gives gilts in the 2014-34 year maturity range a liquidity premium over other issues.
Now, in principle this new premium should have been embedded in prices immediately, when the policy was announced earlier this month.

However, because QE is a new policy, we can’t be sure how a big this premium should be. All that’s happened with this auction is that we’ve discovered that it should be bigger than the market thought yesterday. It’s just part of the price discovery process.

You might wonder why the DMO is issuing long-dated gilts at all, when it could be supplying the more-demanded medium maturities.

This question speaks to an ancient issue in debt funding – the trade-off between opportunistically supplying whatever‘s in demand on the one hand, versus a fixed calendar of auctions on the other. The DMO has been following the latter policy – hence today’s problem.

The argument for doing this is that it reduces the risk market-makers face; if these know what supply is coming, they can run their books accordingly, and this reduces the risk premium in gilts and hence funding costs for the tax-payer.
But it could well be that the size of debt issues required, plus QE, mean that this policy should change, and the DMO should have more flexibility to issue as and when it can.

Whatever, markets are not spooked. Yes, some cash prices fell, especially at the longer end.

But the June long gilt future has had a decent day in the end. Whose opinion would you trust – that of informed traders, or the semi-literate commenters on some blog?

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1. Liberal Conspiracy

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