Update: Trussonomics is dead. Jeremy Hunt on Monday effectively scrapped every key element of Liz Truss’s growth plan. Read the full story here.
A relative dearth of US economic data in the new week won’t likely mean calm markets.
There’s plenty to fret over in China, and on the off chance it slipped your mind, the UK is still embroiled in crisis.
Kwasi Kwarteng’s ouster failed to calm nervous gilts late last week, and they’ll trade without a Bank of England backstop for the first time since September 28 starting Monday. It’s unclear how that’ll go.
The market is still broken as far as anyone knows, and volatility is quite literally off the charts (figure below).
To say Liz Truss’s press conference announcing a U-turn on corporate taxes was insufficient to placate traders would be to woefully understate the case. Truss’s position is untenable in the eyes of many, and I’d expect markets to reflect that.
Jeremy Hunt’s installation as Chancellor will presumably help, but the real problem is the LDI overhang. Nobody knows how close (or not) the pension complex is to completing the haphazard unwind triggered by cascading margin calls. The forced selling isn’t confined to gilts. Far from it. Everything from CLOs to MBS to US and Asian high-grade corporate credit is up for grabs.
And it’s bigger than the UK. “With UK-related selling pressure in US high-grade still evident this week and the endgame still quite unclear, investors are naturally asking about who else may be vulnerable to similar pressures globally,” JPMorgan’s Eric Beinstein wrote, adding that although there are “some idiosyncratic UK-centric drivers of the current situation, a common thread globally is that the large majority of long duration sovereign and corporate debt is denominated in USD, compell[ing] non-USD based investors into taking FX risk to get duration and yield.”
That’s potentially problematic. “This is an issue for asset allocators who spent the past decade playing the ‘survivorship bias’ game of the ‘US exceptionalism’ trade, particularly with foreign entities who FX hedge piling into USD-denominated assets,” Nomura’s Charlie McElligott said. Those entities are “now at risk of what is effectively a de-facto ‘short USD’ position unwind as their currency hedges bleed them.”
On the CLO side, Blackstone, Carlyle, Apollo and others were buying over the past several weeks, as pensions unloaded billions, including a record €1.5 billion during the last week of September. “Demand from money managers has been enough to keep prices essentially unchanged, but lower than when pensions first started selling,” sources told Bloomberg last week. The lowest bids were being rejected, the sources said. If the selling continues (and particularly if it accelerates), you’d expect more pressure on prices as buyers drive a harder bargain knowing pensions are stuck. Apollo reportedly saw quick gains on CLOs bought during the height of the panic.
Needless to say, pressure is building for industry reform. JPMorgan’s Nikolaos Panigirtzoglou estimated the mark-to-market losses for LDI strategies at up to £150 billion since early August. That’s what triggered the margin calls. The funds were leveraged up to four times, he said. As for what assets funds could sell to meet collateral calls, Panigirtzoglou said the following:
Assuming the relative allocations in the Purple Book as of end-2011 are still representative, the 20% allocation to equities would amount to $290bn based on PPF data on total DB pension fund assets of £1.45tr in Sep22. Of this, only a tenth was UK-listed equity, with two-thirds overseas quoted equities and around 20% in unquoted or private equity. The around 72% allocation to bonds would amount to around £1tr, with half of it in index-linked bonds and a quarter each in corporate and government bonds, but while the linker part is likely predominantly UK government issued there is no geographical breakdown of corporate or government bonds. Property, hedge fund and annuity investments each accounted for less than £100bn. In other words, the bulk of potential asset sales would likely be in bonds as well overseas listed equities, and to the extent that UK DB pension funds, or the LDI funds that manage funds on their behalf, have been selling foreign assets to meet collateral calls this could also have presented a source of support for sterling.
As I wrote last week, it’s wholly unrealistic to expect funds to square all of this in such a short window. The “clean up,” as officials and journalists are fond of calling it, could take months, if not longer. So, it’s very likely that the volatility will persist, particularly with the BoE’s support confined to a transitional repo facility. The more volatile things are, the higher the mark-to-market losses. That’d mean more collateral calls and more forced selling across all manner of fixed income and securitized products.
BlackRock is 20% of the UK LDI market. Larry Fink addressed the situation on the firm’s Q3 call last week. “You had risk corridors of 100 basis points to 125 basis points,” he began. “That corridor worked for over 20 years.”
Most readers can probably anticipate what Fink said next. Anyone who read my original assessment of the meltdown certainly can.
“Because of a fiscal policy announcement by the UK government, markets fell over 100 basis points in one day and many of the corridors were penetrated,” Fink continued. “[That] means the clients have to post margin in their total return swaps. Many clients did not have the ability to rapidly post margin in a single day.”
On September 28, just hours after the BoE’s intervention, I wrote the following,
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 pretty urgent.
That was correct, almost to the letter. Because of course it was. What else could’ve happened? This is post-GFC VaR shock 101.
Bloomberg quoted Jim O’Neill, former Goldman economist and current chairman of Northern Gritstone. “We have this enormous financial services industry that pension funds and insurance companies are at the core of, but they typically invest in relatively low-risk instruments. They have taken a lot of leverage to try and get the returns that savers expect,” he said.
Fink tried to be constructive — optimistic, even. “It appears much of the reconstruction of these products may have been done and the market maybe should be a little more normalized,” he told analysts. Subsequently, Fink conceded he couldn’t say whether the volatility had truly run its course. What he did say, though, is that BlackRock wants to part of the solution. “We want to work with the regulators. If volatility is going to continue to be this large, maybe there has to be a whole redesigning of some of the products,” he mused. “As of now, there has been adequate time in most cases, not all.”
That’s what Truss, Hunt and Bailey are up against, and count me in the camp that thinks another backstop from Bailey is just a matter of time. There’s a sense in which this has “already happened,” although any stability Hunt manages to foster would be welcome. He hasn’t ruled out delaying Truss’s plan to cut the basic rate, for example.
In addition to the prospect of another backstop for gilts, the BoE is under tremendous pressure to deliver outsized rate hikes to protect the currency and preempt any inflation impulse that may accompany what the market believes is fiscal recklessness (figure below).
The BoE isn’t excited about the glaring juxtaposition between buying bonds and hiking rates aggressively, hence Bailey’s reluctance to countenance an ongoing safety net for the bond market.
Hunt told the BBC Sunday that he’s taking “nothing” is off the table when it comes to revising tax cuts and public spending. He also insisted Truss is “still in charge.” Unfortunately, that’s the problem. And until it’s fixed, UK assets will almost surely remain under pressure, frustrating as that is for anyone clinging to the notion that somehow none of this is her fault.
“Gilt markets remain volatile as the BoE is due to end asset purchases amid lingering uncertainty around the extent to which pension fund issues have been addressed,” Goldman’s Praveen Korapaty said. “The UK fiscal outlook will remain tied to the gas price despite recent U-turns on tax cuts, so we now expect gilt yields to remain near recent highs of around 4.5% before falling back to 4% through next year,” he added, calling the outlook “highly uncertain.”
“Given QT, high issuance and recent volatility, we expect UK duration risk premium to be elevated during the current cycle,” Goldman assessed.
Hunt claimed he can “show the markets… every penny of our tax and spending plans.” That was another mistake. Because now, markets are going to want to see those pennies. And Hunt will probably have a difficult time producing them, which means, ironically, that the BoE may be compelled to conjure more reserves to put a floor under gilts (or a ceiling on yields, whichever way you want to think about it).
There are two bond auctions this week in the UK. And inflation data for September is due Wednesday.
Three observations. Truss has to go. Bank of England has to buy more long bonds. This is a credit event, so risk free yields should decline shortly.
Which came first, pension funds and insurance companies growing tired of their safe, boring businesses and moving into riskier products vulnerable to black swan events every twenty years or so, or pension funds and insurance companies being forced into riskier products as the collapse of the Soviet Union/NAFTA/China’s integration into the WTO regime/the advent of swaps, etc. drove rates to historic lows? Maybe a little both? Whatever the correct answer, Buffett was and is right about derivatives.
Derivatives serve two purposes. One, they provide protection from certain adverse market events. Two, they produce fee income, something all banks crave because its source generally stays off the balance sheet. When economic growth is shrinking, taking organic growth in revenues with it, derivatives create fees that can raise revenues and profits at a rate above the basic nominal economic growth rate. The more layers of derivatives, the more revenue. From the vantage point of a naive market outsider, it now appears that the actual market instruments underlying the financial derivative structure have become, as Charles Laughton most ably said in “Witness for the Prosecution,” superfluous!