Commentary: Bruises from the Bank's bad timing

What a time to bite the hand that feeds you. Recriminations were last night winging between the Bank of England and the markets over the decision to cut base rates 24 hours ahead of a pounds 2.5bn gilts auction. The fact that the auction was so poorly received was cited as evidence that unless the Bank treats the market nicely there will be problems finding the pounds 1bn a week the Government needs.

The row arose because the period between the announcement of a gilts auction and the day it takes place - eight days - is a sensitive one. Market-makers pre-sell much of the stock they expect to buy at the auction to investing institutions. This means that market-makers go short of stock, making up the difference by buying at the auction. But when base rates fell, gilt prices rose, leaving them committed to buying back more expensive stock to cover their commitments. Some decided on Tuesday they were too exposed, and in effect bought back their pledges to sell stock to investors, reversing the whole process. They thus had less capacity to buy at the auction.

From the market's point of view, the Bank broke an understanding that it does not damage dealers' interests during the auction period. They would like the Government to have been braver about sterling last week, and cut base rates before dealers had gone so short of gilts.

From the Bank perspective, there is indeed an understanding, written into the auction documents, about the critical period, but it does not extend to a promise to keep base rates unchanged. The market must judge such risks for itself, and not expect its local preoccupations to take precedence over the Government's need to time interest rate cuts correctly.

Furthermore, market-makers could have hedged to a greater extent than they did, using futures, rather than taking a punt on the basis that they would be treated nicely by the Bank.

Before Big Bang, the City was always convinced that the two firms that dominated the gilts market were featherbedded with tasty morsels of information and well-timed tap stocks, to smooth the funding process. Things have certainly changed now that there are 19 competing market-makers, and this week that message has been hammered home.

But while there is no case for featherbedding in the old sense, there is still a serious question over whether the market's bruising will affect the Bank's ability to raise money for the Government.

Investors, not market-makers, ultimately determine demand for gilts. But at the margin, there may have been some damage, as market-makers take a more cautious approach at the next few auctions. With so much to sell, the Bank may come to regret this week's bad timing.