Helping the Banks is not free

That old supply and demand, the moment you forget about it, it sneaks up from behind and bites you in the backside. While the Bank of England was preparing to save the banks, Goldman Sachs was telling their clients that the rescue plan would flood the market with long term government debt and therefore advised them to "short" UK paper.

What happens when supply increases? The price goes down. Then there is that other special relationship in finance - interest rates are inversely related to bond prices. More supply means lower prices and higher interest rates. The UK bond market did not forget any of this last week. Yields on 10-year government paper surged from 4.43 percent to 4.71 percent.

The surge in 10 year yields was a timely warning that the Bank of England's plan could involve a considerable cost for the UK economy in terms of higher long-term interest rates. The plan is based upon a potentially huge increase in the supply of government paper. Mervyn King even promised the banks that there was "no arbitrary upper limit". Although the plan might start out at £50 billion, it could quickly go beyond £100 billion and beyond.

Make no mistake, the rescue plan has serious implications for the government debt market. According to the Bank of England, at the end of last month, there was ₤528 billion of government net debt. Adding a further ₤50-₤100 billion is bound to upset the market slightly.

Things might be containable if this was the only worry. There are two other factors threatening to destabilise the bond market - the Bank of England's current asset injections and a growing fiscal deficit.

Since the credit crisis began, the BoE steadily injected large quantities government paper into cash strapped commercial banks. A quick look at the BoE's balance sheet suggests that it has already injected some ₤20 billion by reducing its holdings of short term repos, and a further ₤6 billion from the government's ways and means accounts. These government assets are now held by commercial banks via longer term reverse repos. The following chart gives a flavour of this huge injection of government paper into the financial system.


Darling and Brown aren't helping much either. The government is running up a sizable fiscal deficit, which needs to be financed by further sales of government paper. So far this fiscal year, the government has borrowed some ₤35.6 billion. More deficit means more debt, lower bond prices and higher interest rates.

A large fiscal deficit, the BoE's new liquidity arrangement, and its pre-existing asset injections - add it all together, and it is not hard to see why Goldman is expecting UK bond rates to rise.