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.”