September 28, 2022, was the day central banks were forced back into intervention mode.
For weeks, I’ve argued that the stronger dollar, bolstered by ever higher terminal rate pricing in the US and relentlessly higher real yields would eventually prove untenable. Something, I said, would break.
As it turns out, that something was the UK bond market, and although the rout was plainly catalyzed by Liz Truss’s disastrous fiscal unveil, it’d be a mistake to conceptualize of Truss’s budget boondoggle as something that happened in a vacuum. Her plan was a product of onerous macro circumstances which put the UK on course for a prolonged bout with severe stagflation. And those macro circumstances are the story of the 2020s.
Additionally, the pound wouldn’t have been so vulnerable were it not for the dollar’s inexorable rally, and the only circumstances under which a Bank of England that hikes seven consecutive meetings, including two straight 50bps increments, would be seen as behind the curve, are those which include a Fed that hikes 75bps at three straight meetings.
The UK’s plight is both idiosyncratic and not. Truss didn’t have to screw up as badly as markets plainly believe she did (and we have to separate the market’s judgment from our own in these discussions), but she did have to do something. And, as discussed at length here, there aren’t any good options.
The problem (well, one of many problems) is that Truss and Kwasi Kwarteng didn’t anticipate how quickly things might go awry. To be fair, I’m not sure anyone else did either. But by Monday, market participants in the UK were on high alert. According to one source who spoke to Bloomberg, the BoE was warned in recent days about the potential for margin calls “as soon as Wednesday afternoon.” “This morning I was worried this was the beginning of the end,” a senior London-based banker quoted by the FT said. Apparently, there were no buyers at all for long-dated gilts at one juncture. “It wasn’t quite a Lehman moment. But it got close,” the same person said.
At issue were pension funds and the potential for the selloff in gilts to trigger a cascade of liquidations, which would’ve exacerbated an already historic meltdown. Fearing a total collapse, the bank stepped in. The ensuing rally was nothing short of breathtaking. 30-year gilt yields fell more than a full percentage point (figure below).
“Today’s action from the BoE is pure and simple a pension fund bailout,” Nomura’s Charlie McElligott wrote. One rates strategist at HSBC told Bloomberg that “thousands of pension schemes” were up against “urgent” cash calls.
If the BoE had let the process run its course, the liquidations and attendant yield surge would’ve further undercut pension funds, necessitating still more collateral until there was nothing left. One LDI manager who spoke to the FT for the same linked article above said gilt yields might’ve jumped as much as 350bps absent intervention, resulting in nearly every UK pension fund being “wiped out.”
This is the same story again and again. Conceptually, anyway. It’s just a VaR shock. You could write the boilerplate copy in your sleep. Liability-driven investors likely use some manner of probability distribution to determine collateral requirements. The models couldn’t cope with the two-day surge in yields, which was wholly anomalous in standard deviation terms. More colloquially: Something that wasn’t supposed to happen happened.
Once the risk limits were exceeded, the margin calls rolled in. To meet them, fund managers either started selling or were about to. Someone called the BoE and said, “Hey, here’s what’s going on, you’ve gotta do something or else there’s gonna be a crash. A real, honest-to-God crash.” The urgency of the situation would’ve been commensurate with the amount of leverage deployed. And the situation was apparently pretty urgent.
Again, this is all laughably familiar, assuming you can find humor in an objectively unfortunate turn of events. It’s not necessary to know anything about LDI funds to understand what (probably) happened, nor does one need to be any sort of specialist to suggest that the same dynamics which defined the post-Lehman era were in some way, shape or form, in play here, where that means the entire setup likely depended on a false sense of security brought about by a decade of subdued volatility underwritten by central bank forward guidance.
McElligott alluded to that Wednesday. “The spiral of forced-selling to make cash calls is further evidence that widespread deployment of leverage across strategies from the halcyon days of QE and the central bank vol-suppression era is no more, and that systemic de-leveraging is now at an acceleration point, particularly as ‘risk-free’ assets used as collateral turn to meme stocks,” he wrote.
That latter quip isn’t so much a quip as a lament. Bonds (rates) are more than just the sponsor of 2022’s rolling bear market across assets. They’re a source of portfolio volatility, increasingly prone as they are to multi-standard deviation moves that make a mockery of the bell curve and every model built on it. (Maybe we should stop building models on it.)
At the same time, liquidity is very poor, and market functioning severely impaired. That just adds to the GameStop-ification of DM government bonds. As a reminder, US Treasury liquidity is as bad as it was during the original pandemic meltdown (figure below).
Yet somehow, Janet Yellen saw no signs of liquidity issues or deleveraging. “We haven’t seen liquidity problems develop in markets,” she told reporters in North Carolina on Tuesday afternoon, adding that, “To the best of my knowledge,” there’s no evidence of “the kind of deleveraging that could signify financial stability risks.”
Apparently, Yellen wasn’t privy to the discussions the BoE was already having with investment banks and fund managers in the UK. Just 12 hours after her remarks, the BoE intervened citing precisely the sort of liquidity problems, disorderly price formation and generalized dysfunction she claimed wasn’t occurring.
Coming full circle, the lesson from Wednesday is that central banks now confront a terrifying reality. Tightening policy to fight inflation risks systemic meltdowns. After a dozen years, markets adjusted to a new reality defined by the short vol trade in all its various manifestations. Investors were forced out the risk curve, down the quality ladder and into leverage to generate yield. That was all underwritten by staid monetary policy and predictable forward guidance. That policy bent is no longer tenable. Inflation is too high, and combatting it is a political imperative.
That means that in the presence of a shock which threatens to tip various dominoes, central banks will have to choose between sticking with the inflation fight or preventing systemic blowups. As one PM at Allianz put it Wednesday, the BoE “could be the first DM central bank that’s pivoting, where what’s a temporary measure could well become long-term.”
I admit to knowing nothing about pension fund management, but why are pension funds deploying margin? Seems… a little absurd.
Just my “guess” is : Some wise CYA “consultant” hired at an egregious rate recommended they put put money into vol-control and other risk-parity strategies. Many rely on the use of futures and forwards, which may explain the margin calls.
I don’t think they necessarily do. The massive rise in rates hit certain risk limits in their models (probably certain VaR limits) and they had to start selling. The massive falls would also have precipitated an increase in margin calls; and in order to cover losses, those investors were then forced into selling government debt. The whole thing then fell apart.
A lot of that is because they’re trading in futures markets. Futures are traded bilaterally, so you have to post collateral with a large number of potential counterparties. For the market to function at all, that collateral has to be a relatively small amount in proportion to the size of potential positions. As such, the funds needn’t have been leveraged at all to be exposed to large potential margin calls with certain counterparties.
Matt Levine’s column today explained this. Essentially they were levered long on safe government debt so that they would not seem underfunded in the event that interest rates fell.
In political economy terms, the global fight against inflation is existential; nothing less than the survival of liberal democracy is at stake. If, going forward, that fight requires a two-step forward one-step back approach, so be it. At the end of the day, inflation must be suppressed and the CB-enabled keep-the-profits-socialize-the-losses paradigm must be kicked to the curb.
So you would’ve had 90% of UK pension funds fail today if it were up to you? Because that’s where it was headed.
No, the emergency QE seems entirely appropriate in the circumstance. But as more things start to break, we all need to be clear about who is getting bailed out — and why.
Is it not possible for England to take the same 65b it used to stabilize the treasury market and simply make pensions ‘whole’?
Seems like an excellent question, and I would love to hear someone with actual expertise in financialized markets (i.e., not me) explain why that was a non-starter.
I saw somewhere that BOE was about to launch QT on Monday. If they do, they will have simultaneous QT and QE. I guess the thing to watch going forward will be the sign and magnitude of QE minus QT. Combine that with inflation and rate hikes and you have something truly exotic to contemplate. Like high inflation stagflation maybe?
No, they postponed the onset of QT until October 31. That was in the announcement today. But it won’t matter. Markets will obviously question whether the new plan is viable. The idea is to keep buying long-dated bonds as necessary until October 14, then commence QT on October 31. I have my doubts.
This situation as outlined by H here is at the crux of the issue developed nations and the merry group of technocrats in charge of policy face. This is the moment we’ll have to be honest, the only way to really tame inflation will also result in calamitous financial events and market meltdowns that are simply too high a price to pay, just ask any UK citizen if they rather pay more for everything or have their pension savings vanish. We must learn to live with elevated inflation and let some of that inflation reduce the % of sovereign debt to GDP, YCC is looking more like the final destination for all DM economies.
This stuff was not covered in the 1950s economic models the Fed still relies on. Maybe some updates need to be done. Start by bringing in people who actually worked on funding and trading desks on the street, not the couple of ex-M&A dealmakers they have.
Rishi Sunak is looking better to the average stunned Tory MP, perhaps? Anyone have a source for bookie odds on a no-confidence vote for Truss?
Stunned is right. This happened so fast, and was so dangerous, that I don’t think the vast majority of people — any people — have had a chance to wrap their minds around it yet. Expect a ton of “Here’s How Close The UK Came To…” articles from the mainstream media over the next week.
Yes, you have to think that perhaps the whole setup of derivatives that we have should not be legal. Is there a regulatory scheme that could make finance boring again? Or is that not really at the heart of the problem?
I have to revise my earlier comment to a different post. Today saw the emergence of two new CB balance sheet tools in addition to QE and QT. This morning we got “QE cum QT” from the BOE, which apparently came hot on the heels of Yellen’s new forged in Japan “See No Evil” tool. (Meanwhile, ironically, the yen barely managed to lift its chin off the floor).
Is no one concerned that we seem to have moved beyond simple moral hazard here? Fiscal lunacy now seems incentivized. Massive tax cuts for the wealthy plus central banks stimulus to prop up the markets is a a double barreled wealth hose to the richest brits (and foreigners involved in British markets). If CBs paper over deleterious effects of incompetence (protecting the masses from the worst of the harm while doling out financial incentives to the rich) its frighteningly Pareto optimal.
A model I hope doesn’t spread but expect to see increasingly more of.
Hence, we have cryptocurrency.
+1
I do not really grasp why UK pension funds got into this near collapse situation, some enlightenment would be helpful. But isn’t the underlying weakness then really either bad liquidity management on the side of the UK pension funds and/or structural issues that they can’t fulfil long term pension obligations. Where I live (NL) defined benefit was replaced by defined contribution pensions many years ago, which makes it hard to believe such market movements, although not insignificant, would cause a risk of collapse. This does not take away the obvious fact UK government misjudged.
It also really interests me, because i’m heavily invested into EU banks, which also really plunged starting last friday, I’m trying to understand the obvious contamination risk effect.
Apologies, this whole situation has me riled up. When I see what is happening in the UK, and what is happening more generally in global macro, the analogy that comes to mind is wildfire management (or lack thereof) in California. With the help of a benign neglect attitude on the part of regulators, a lot of bad stuff has built up in the global financial system since at least Glass-Steagall was trashed during the Clinton years, and it’s high time it was cleared out. How to do that is another question entirely.
Excellent analogy
Most Defined Benefit schemes (outside of the public sector) closed decades ago, but you can’t strip people who are on Defined Benefit schemes from the past of their Benefits! So they still exist and will do for a few decades yet. As for the Derivatives being employed, even buying a Long Dated Bond on repo would cause issues given the scale of the moves we have seen.
Great piece Heis.