‘Test And Fail’: The Worst-Case Scenario

Earlier this month, BofA’s global equity derivatives team warned of a “test and fail” of the vaunted central bank put.

The idea is that policymakers are constrained in their capacity to backstop markets by the primacy of the inflation fight.

That’s dangerous enough on its own, but the most perilous aspect of policymakers’ predicament in 2022 is the fact that markets are apprised of central banks’ reluctance to jeopardize progress along the road to tighter financial conditions by reinstating the put.

Gunning down bond vigilantes and serving as a lender (or, in modernity, a dealer) of last resort are endeavors that generally entail taking steps that look a lot like policy easing. So, preserving financial stability can be tantamount to easing, and easing is tantamount to tossing gas on the raging inflation inferno. Stoking the inflation flames is anathema. Markets know that, so why not test policymakers’ mettle?

The answer in the US context is because you’ll lose. By virtue of the dollar’s reserve status, Jerome Powell isn’t subject to the same constraints as his global counterparts. That’s not to say a Fed intervention to, for example, improve Treasury market liquidity, wouldn’t be chastised as a potential inflation accelerant (it would), it’s just to say it wouldn’t trigger a crisis like that currently gripping the UK bond market, where BofA’s warning is being borne out in real time.

I realize I’ve written voluminously on this over the past three weeks (where “voluminously” means I could single-handedly anchor a mainstream media outlet’s news desk), but it’s impossible to overstate the importance of what’s happening to the UK. Note that the entirety of the relief rally brought about by the BoE’s intervention in long-dated gilts was history as of noon in the US on Wednesday (simple figure below).

This is a very fluid situation, so by the time you read this, that chart could look quite different. But for the purposes of this discussion, it doesn’t much matter, nor does it matter whether Andrew Bailey is perhaps enlisting markets in a game of chicken with Liz Truss, with the ultimate goal of compelling a fiscal U-turn.

Rather, what matters here is that whether it’s ongoing forced selling and unwinds, or simple shooting against wounded UK assets, long-dated gilt yields are poised to exit the BoE intervention window at the same nosebleed levels which prompted intervention in the first place.

There are myriad unanswered questions, not least of which center on the apparent discrepancy between shrill calls for an extension of the bond-buying program and what, on my (admittedly cursory) examination, looks like lackluster take-up at the daily operations. “My best guess [is] that many of these pensions (and, frankly, many structural buyers of fixed income) are incredibly reluctant to book these exorbitant losses inside their portfolios across assets and strategies, expecting instead that the BoE operations would be extended indefinitely until forced ‘fire sale’ flows are exhausted and liquidity is properly managed again, which would in turn allow funds to take marks-to-market at far better prices,” Nomura’s Charlie McElligott said Wednesday.

That’s probably true. And it’s also worth noting that before the linker drama took over the headlines, the BoE did announce a new repo facility aimed at smoothing the transition from emergency bond-buying.

A lot of that begs the question, though. It all comes back, one way or another, to the idea that the central bank backstop, and the core responsibility of central banks to serve as a dealer of last resort in a crisis, is being tested, and will likely continue to be tested as long as there’s a tension between the financial stability mandate and the inflation fight.

On Wednesday, following Bailey’s insistence that emergency purchases will end as scheduled this week, the BoE saw the biggest take-up yet at its daily operations (figure below).

The bank bought £4.6 billion of long-dated gilts and linkers. In just the last two days, they bought more than they did over the entire first nine days of emergency buying.

In the context of the “dealer of last resort” characterization, consider what’s reportedly happening at UK pension funds. The turmoil in gilts (and, again, long-dated yields were back near pre-intervention levels and there’s no indication that the volatility is going to subside anytime soon), will continue to put pressure on these strategies. If the market keeps shooting at UK rates, that’s going to lead to more volatility and more margin calls, unless you believe two weeks is enough to restructure an entire industry (it’s not). Any related fire sales, de-leveraging and repositioning won’t be “contained.” Not entirely, anyway.

“We know that the spill over of the forced cash-raising for margin calls via selling of ‘liquid alts’ / public markets like sovy bonds, corporate credit and equities, as well as investments in alts like hedge funds and longer cash tie-ups like PE, VC and real assets, is dictating all sorts of second-order impacts,” McElligott went on to say, adding that there’s a growing body of evidence to suggest this “is a global issue, and beyond just the pension industry.”

Bloomberg this week talked to Elaine Torry, a consultant who, as it turns out, predicted this debacle in March. “The shifts in allocations by a sector that manages over $1 trillion in assets will impact everything from gilts to equities,” Greg Ritchie wrote, summarizing his chat with Torry who said, among other things, that “in the conversations we’ve had, every option was on the table in terms of where cash can be raised.”

Crucially (and this is the obligatory, ubiquitous asterisk/caveat), Ritchie reminded Bloomberg’s readership that “higher bond yields are generally a good thing for defined-benefit pension programs as their liabilities are calculated in reference to market rates,” which means that although “the sharp nature of the selloff has caused short-term liquidity issues, in the medium- to long-term it may allow these funds to adjust their risk appetite.” The problem is that a short-term liquidity crisis is to long-term solvency what a gunshot to the stomach is to an otherwise perfectly healthy ER patient.

I guess what I wonder, ultimately, is how this all develops in a worst-case, near- to medium-term scenario. These are forced sales to cover cascading margin calls, and the forced sales have the potential to create more margin calls through the impact on prices. Eventually, you run out of liquid assets to sell. At that point, you’ve got two problems. First, you’re overweight illiquid assets. Second, if you need to sell them, you can’t, because they’re illiquid. I don’t know how the marks work for that industry or even if that applies, but what I do know is that in a crisis accompanied by extreme macro turmoil and rampant uncertainty, illiquid assets are de facto worthless, at least temporarily, and once you exhaust any interest from opportunistic private equity and distressed debt players. At that point, and assuming conditions don’t improve, the only option is pledging assets to a dealer of last resort — so, a central bank, and likely with massive haircuts.

We’re not anywhere near that point yet. Or maybe we are. To be honest, I don’t know. And as far as I can tell, nobody else does either. These sorts of situations can go from bad to catastrophic almost overnight. Just ask September 28, 2022. Fingers crossed that this is, as some still insist, an idiosyncratic problem confined to the UK. And that the dynamics (and therefore vulnerabilities) across locales aren’t the same.

BofA’s global derivatives strategists, led by Benjamin Bowler, addressed both of those points in the same October 4 note mentioned here at the outset, albeit not directly through the lens of pension schemes. “While it may seem like the UK experience of the past week is an idiosyncratic phenomenon that may remain isolated to the UK, we are concerned about the read-through to broader market psychology with respect to the belief in the ability of central banks to provide relief when it is most needed while they are already severely constrained by persistently high inflation,” they wrote. “The fact that the BoE needed to intervene in the gilt market to stave off bond market turmoil ahead of potentially forced selling highlights the consequences of putting a levered financial system through one of the fastest and most coordinated series of rate hikes in history.”

I’ve used those quotes at least twice over the last several weeks. I imagine I’ll be using them again. While I’m no expert on pensions, let alone on the idiosyncrasies of pension schemes across locales, I’m confident in asserting that there’s no strategy, scheme or market contrivance of any kind to which warnings about the perils of subjecting leveraged positions to rapid rate hikes don’t apply.

The good news is, there’s likely to be some interest out there in the event of ongoing fire sales. “It’s unnatural for a bond investor, a credit guy, to actually be excited about the markets,” Apollo deputy CIO John Zito told Bloomberg on Wednesday. “And the times that you get excited about the markets are frankly when everybody hates the world.”