Uppers and Downers
This week, the Bank of England was forced to stabilise the UK Gilt market… again. The reason being, much to PM Truss’ dismay, economic chaos continues to reign.
The volatility in UK Gilts has led to huge pressure in the pension sector and their liability-driven investing (LDI) strategy, a strategy that, until recent days, didn’t enjoy much of the spotlight. Unbeknownst to many, LDI makes up a massive part of UK pension investing and the perilous situation into which it fell forced the Bank to go on a Gilt shopping spree. But even that hasn’t settled UK markets.
LDI’s importance
The LDI situation is brilliantly explained by Bloomberg’s Matt Levine here. In short, it’s a strategy designed to protect pension schemes from having to report accounting losses when rates go down. (Rates go down, the pension funds “underfundedness” goes up. So pension funds enter into huge swap agreements to hedge against lower rates). Stress tests against these hedges are typically carried out to account for <1% moves in yields, however, recent swings in the Gilts market have been so severe that schemes were forced to dump assets to meet margin calls. It’s rumoured that some were hours from collapse.
With £1.5tn held in LDI-led UK funds, the size of the potential blow up fuelled fears that savers’ cash was in jeopardy. Hence, the BoE announced on September 28th a two-week emergency purchase program of long-dated Gilts. The plan remains that the BoE will “end these operations and cease all bond purchases” on Friday 14 October.
UK fund managers have been fast tweaking and rowing back on the leverage used in their LDI strategies as they try to reassure investors and the market. BlackRock said it was slashing leverage in its LDI funds and boosting liquidity, whilst L&G moved to reassure investors of its liquidity. The words of a UK Chancellor have rarely had such a consequential short term impact.
A global risk
The UK is not alone. LDI strategies are employed globally by corporates who use debt to invest in a mix of assets that offsets the volatility in their liabilities, with the aim being for a scheme’s assets to move in line with the value of its liabilities as rates and inflation rise and fall.
Leverage is key in LDI strategies, and, as the FT states, it “offers pension funds, basically, a way to look like they’re an annuity without making the full capital commitment of becoming one.”
The approach is incredible to me, especially the fact that these funds want to avoid reporting accounting losses (not real losses) on their balance sheets. As a consequence, fund managers are forced to carry out risky swap trades that, to all intents and purposes, make them both massively levered and long gilts. Of course, this makes no sense, as a DB pension fund should be thrilled when gilts sell off and rates go up! Matt Levine sums it up beautifully when he says,
“I know this is bad but I find something aesthetically beautiful about it. If you have a pot of money that is immune to bank runs, over time, modern finance will find a way to make it vulnerable to bank runs.”
Between a rock and a hard place
As you might imagine, and this excellent piece in FT’s Alphaville points out, the BoE now finds itself caught between a very hard rock and a very hard place. Before Kwarteng’s fiscal event, the BoE had planned to sell gilts (as part of unwinding its decade long QE program), but this seems to have been delayed indefinitely.
Whilst the Gilt fire rages, the BoE is also trying to keep the smoldering inflationary volcano in check. Despite efforts to protect the mortgage market, there’s no way they can avoid pushing up rates. Which do you think is the lesser of two evils: The Gilt market skyrocketing or the UK property market erupting? The BoE wants to protect both, but as Nomura’s Charlie McElligot says:
"So here we are, with the BoE mixing “uppers” with their “downers,” drinking Red Bull Vodkas as they simultaneously hit the gas and brakes in chaotic fashion.”
Spot on, and alarmingly so. Landing safely whilst ingesting all that and after having pumped both pedals with both feet is a stunt even Evil Knievel would be proud of.
A looming threat
In addition, an element some commentators seem to be missing is how pensions and insurance companies own a whopping third of all outstanding Gilts.
If that sector flips from being a net buyer to a seller, which it might as rates rise, the BoE is going to need a vast amount of firepower to absorb the balance. Whatever they choose to do, its impact will be hugely inflationary, and that’s why I’m seeing a lot of smart people already price in a 100bp rate rise in the front end.
Such a hike could be nigh-on catastrophic for the mortgage market, which in the UK is reliant on short-term fixed deals in the 2-5 year range. But it might be the only way for the Bank to untie itself from the Gordian Knot it finds itself in. Some mortgage holders’ blood might have to be spilled if the UK economy isn’t going to fly off the tracks and go up in flames.
Nowhere to run
Amidst all this, we are waking up to news that Chancellor Kwarteng has returned to London early from the IMF meetings in DC, with plans to review the major components of the mini-budget. U-turns over the weekend are expected.
While the gilts and sterling have had a bit of a relief rally in anticipation of the government rolling back on its fiscal plans, I expect this to be short lived. Experience from other financial crises has taught me that the first intervention is never sufficient, and after a relief rally, things tend to get worse before they get better. After the mistake of Lehman…Goldman, Morgan, AIG, and everyone else were bailed out but markets fell for another 6 months (from Oct 2008 to Mar 2009) before finally reaching a bottom. Reversing £18bn of tax cuts out of £43bn that were announced will be insufficient. Replacing the PM and Chancellor will probably be insufficient. It may well be that gilts continue to slide until the government is ultimately replaced at the next election (whether that’s in 2024 or earlier).
Writing a piece like this is difficult because it’s all too easy to end up with a listicle of misery, a menu of impending economic disasters, both short and long term. But I’m not sure if anyone has any solutions right now that don’t involve quite a bit of pain for quite a large portion of people, whether they be home owners, people on benefits, bond holders, and everyone in between.
I don’t have a solution. Far from it. All I can say is how interesting, no, scary it feels to put the UK at the centre of a global macroeconomic story du jour in the same way we once wrote about Lehman, Greece, Italy and, even, riskier elements of crypto. But that’s where we are. And however we got here, and whoever is to blame, the road ahead looks rocky to say the least.
