By Geoffrey Smith
Investing.com -- The dollar was broadly higher in early trading in Europe on Tuesday as the pound weakened amid fresh signs of trouble in the U.K. government bond market.
The Bank of England said it would widen its purchases of Gilts to include index-linked bonds, after a disorderly selloff in the asset class on Monday which appeared to be triggered - again - by pension funds raising cash to meet margin calls on longer-dated interest rate swaps.
"Dysfunction in [the index-linked Gilt] market, and the prospect of self-reinforcing ‘fire sale’ dynamics pose a material risk to UK financial stability," the Bank said in a statement, announcing its decision.
The move raises doubts as to whether the Bank will be able to end its outright purchases of Gilts on Friday as planned. On Monday, it had said it would replace the daily auctions with repo operations, whose effect on the money supply - and consequently inflation - can be mitigated by other actions to manage the money market.
Index-linked bonds are arguably the safest security in U.K. financial asset universe, given that their returns are pegged to inflation. The sight of them experiencing what the Bank called "fire-sale" conditions is unprecedented in recent history.
By 03:00 ET (07:00 GMT), the pound was down 0.4% against the dollar at $1.1013, having initially broken through the $1.10 level. The dollar index, which tracks the greenback against a basket of six advanced economy currencies, was up 0.2% at 113.28.
During the Asian session, the dollar had touched its highest level in two weeks after Federal Reserve vice-chair Lael Brainard repeated that the central bank will keep raising U.S. interest rates in the near term, amid signs that the labor market is proving resilient to the tightening of monetary policy seen so far.
That prompted traders to increase their bets that the Fed will hike the fed funds rate by 75 basis points for the third time in a row when it meets at the start of November.
However, both Brainard and, before her, Chicago Fed President Charles Evans had also said that the Fed needs to be cautious with any future rate hikes, acknowledging the risk of overshooting.
"The Fed's relentless and most aggressive tightening cycle since the early 1980s is starting to create a few casualties," said ING analysts Chris Turner and Francesco Pesole in a note to clients. "Though the wounds in U.K. asset markets were self-inflicted, the occasion did show that the tighter liquidity conditions being created by the Fed are leaving no margin for error."
Elsewhere, the Hungarian sunk back toward the all-time low it hit on Monday amid concerns that the missile attacks on Ukrainian cities at the start of the week signal a new escalation of the war in Ukraine. President Vladimir Putin threatened more "severe" actions, and various reports indicated thousands more Russian troops would be deployed to Belarus in what was seen as a possible prelude to another invasion of Ukraine from the north. Russia's first invasion from Belarusian territory ended in ignominy in March after its troops ran out of fuel.