By Christina Fincher
LONDON, Aug 7 (Reuters) - The Bank of England's decision to widen the range of gilts it buys for quantitative easing purposes may smooth out some kinks in the yield curve but will do little to ease overall liquidity problems.
Along with its announcement of an additional 50 billion pounds ($83 billion) of asset purchases on Thursday, Britain's central bank said it would start buying ultra-long bonds for the first time, as well as short-dated gilts with maturities of between three and five years.
In truth, it had very little choice. Having already bought 125 billion pounds of 5-25 year gilts since March -- more than half planned issuance for the entire year -- the BoE was sitting on as much 70 percent of some gilt stocks, creating huge price distortions.
However, spreading its gilts purchases more widely will throw up new problems, particularly at the long end of the curve where liquidity is patchy and where a drop in yields could inflate pension funds' deficits.
"It's like squeezing a tube of toothpaste. You resolve the bulge in one place and it moves somewhere new," said one gilts trader.
In a bid to improve liquidity, the BoE has introduced a scheme to lend investors gilts it has bought. However, this scheme comes with a fee and analysts are sceptical it will have much impact.
"The BoE's move may take pressure off individual stocks but it won't improve the liquidity of the market as a whole," said Marc Ostwald, a fixed income strategist at Monument Securities. "We've got choppy trading for some time to come."
FEAST TO FAMINE
Talking about illiquidity may seem strange at a time when gilt issuance is soaring as the recession raises the government's borrowing needs.
Britain plans to issue a record 220 billion pounds of gilts this financial year, more than four times the annual average of the past decade. However, if you subtract the 175 billion pounds or so that the BoE buying, net issuance is just 45 billion pounds, the smallest total since the 2002/03 fiscal year.
Given demand for gilts increases during a recession, it is easy to see that, temporarily, there may not be enough gilts to go round.
Indeed the BoE's government bond purchases dwarf those made by either the Bank of Japan or the Federal Reserve. The size of its QE programme relative to that of the economy also tops the table at 12.6 percent of gross domestic product.
When it began its quantitative easing programme in March, the BoE only bought gilts with maturities of five to 25 years. Buying very long dated gilts, it argued, could be disruptive for pension funds since a fall in long-dated gilt yields would force down the rate at which liabilities were discounted, thereby inflating pension fund deficits.
A strong equity market rally since then may have reduced the BoE's worries on that score, with European share prices up 20 percent since mid-March when QE started.
Thirty-year gilt yields
"A drop of 30 basis points in long-dated yields may sound worrying for pension deficits but it is peanuts when you consider how much equities have rallied in the last couple of months," said Francis Diamond, a gilts strategist at J.P.Morgan. (Editing by Andy Bruce)