Let’s get one thing straight: The selloff in UK bonds accelerated when Kwasi Kwarteng unveiled Liz Truss’s growth plan late last month.
That much is irrefutable. It’s right there on the charts. Anybody can see it for themselves. Implied vol surged, sterling collapsed and so on. To deny any of that is to inadvertently concede one’s own hopelessly biased agenda, to perpetuate “alternative facts” and to effectively ask, “Who you gonna believe, me or your lyin’ eyes.”
Additionally, suggesting that subsequent increases in UK yields were attributable to pension fund unwinds as opposed to concerns around the budget is to beg the question. It’s a distinction without a difference. If the bond selloff accelerated as a result of the fiscal unveil, and pension fund collateral calls were the result of that acceleration in bond yields, then associated forced selling was likewise the result of the fiscal unveil.
Believe it or not, all of that needed repeating on Monday, following Jeremy Hunt’s historic repudiation of the Truss growth plan. Hunt’s decision to nix virtually all of the tax cuts facilitated a knee-jerk rally in gilts and the pound. UK yields plunged (small shaded circle in the figure below), and sterling rallied smartly.
Hunt is now in control of the UK government. There’s little question about that. One MP called Truss “catastrophically incompetent.”
Conservative MP Charles Walker, who spoke to Sky News’s Beth Rigby, said “I can’t think of a time in my 17 years as an MP and my 40 years in politics that there’s been just such a monumental foul up.”
With all of that said, it’s crucial investors don’t lose track of the bigger picture — of the longer-term story. If you’re a regular reader, there’s no chance of that (no chance you’ve lost track of what matters, I mean), but for anyone who’s new, I want to reiterate, this time by way of soundbites from hedge fund managers, that the pension debacle is ultimately a manifestation of a broader phenomenon. And it was the LDI meltdown which threatened to plunge the UK into an outright crisis. In that sense, Truss and Kwarteng aren’t to blame.
I don’t want to spend too much time recapitulating. The point is to highlight a few good quotables, not paraphrase my own editorializing. Those who need a refresher are encouraged to review Sunday evening’s “gilt trip,” and especially “Pension Panic Puts Central Banks Back In Intervention Mode,” in which I spelled things out in more detail.
For our purposes here, consider what Paul Marshall, of the $62 billion Marshall-Wace fund, had to say about the debacle. “The UK LDI industry is the first casualty of the end of the ‘money for nothing’ era,” he wrote to investors, calling the pension collateral calls and forced selling “the first dead fish to float to the surface as rising central bank interest rates act like dynamite fishing in global asset markets.”
I said I wasn’t going to recapitulate, but the temptation is too great. On September 28, I wrote that the lesson from the BoE’s pension fund bailout was that central banks are confronting a terrifying reality. “Tightening policy to fight inflation risks systemic meltdowns” because 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 and into leverage to generate yield, and it was all “underwritten by staid monetary policy and predictable forward guidance,” neither of which are tenable given sky-high inflation and the political imperative of combatting it.
For his part, Crispin Odey said that although “everyone wanted to blame [Kwarteng] I believe it was really 20 years in the creation and brought about by the unstoppable rise in prices.” Marshall expressed similar sentiments, on the way to warning that central banks face a “painful path” ahead. Like Jamie Dimon and Larry Summers, Marshall expects more “casualties.” “It will be interesting to see how central banks react when these casualties float to the surface,” he added.
The overarching point (and this brings us full circle) is that if you’re looking to assign blame to someone other than Truss, you have to take a longer-term view. Just as it’s absolutely the case that the near-term panic was the result of the mini-budget, it’s absolutely true that the policies run by central banks over the past dozen years set the stage for VaR shocks. The LDI blowup won’t be the last one.
Truss plan was reckless. She is now out of domestic policy making and only has input on foreign affairs and likely she will be gone pretty soon.
It is policy advising malpractice to advise central banks to raise rates and cut balance sheets quickly, when in the same breath you say it will cause a major downturn and financial crisis. A hedge fund guy I understand. They make money that way. But Larry Summers and Mohamed El-Erian should know better. It shows a complete lack of empathy and a lack of wisdom.
“…confronting central banks is a terrifying reality, “Tightening policy to fight inflation risks systemic meltdowns””
Yes, this absolutely terrifies me- on behalf of the entire world!
I am betting/hoping that the Fed is extremely aware of how close or not close the global financial system actually is to the edge of the “cliff”. No one in their right mind would want to drive off that cliff, even if we have to live with higher inflation for longer. Seems like a reasonable price to pay to avoid a systemic collapse, including all of the aftershocks.
I vote (haha) for a long “pause”.
They don’t even have to pause. They could start by skipping a meeting or just going a quarter point. It’s the path to the destination (lower inflation) that is sustainable. My theory is that if they raise rates too hard and too fast that they will just be in the soup again, cutting rates fast and then having to resort to QE. If they do it slower, it might actually stick and be less procyclical. My beef is not raising rates per se but going overboard and having to reverse course quickly. They are well on their way to fighting the last war and losing.
H-Man, they took a nutty idea and put it back in the trash bin. Now they have to deal with the problem that caused that nutty idea.
I tend to think commentators are a bit severe here with the CBs. That’s a common feature on financial blogs/twitter etc.
In reality, I would put a lot of the blame on governments : they often decided to adopt austerity/smallish fiscal support post 2008 (though they were okay blowing their wad pre crisis on foreign wars and tax cuts) and now that we saw they overdid it responding to COVID, they refuse to raise tax rates.
I can understand why. Voters apparently prefer to lose money via inflation than via taxes. But it’s still a lack of political courage and will that is the primary cause of all this (or voters’ ill understanding of economics and biases if you want to go further up the causal chain but we got the humanity we got, not the one we wish for – till genetic engineering sorts that out)