Are We at the “Oh SH*T” Moment Yet?
Last week was highlighted (or lowlighted depending on your view) by U.K. Prime Minister Liz Truss and Chancellor of the Exchequer Kwasi Kwateng’s ridiculous “mini-budget” that proposed a huge, unfunded tax cut for the wealthiest citizens to allow the economy to grow itself out of a currency in free-fall, soaring interest rates and crippling inflation. The plan is titled “Get Britain Moving Again!” The plan certainly got things moving again, moving rapidly in the wrong direction. The UK Gilt (Treasury bonds) market reacted to the plan to kill inflation with inflation by crashing along with Pound Sterling. Unfortunately, as long dated Gilts dropped as much as 30% in the two trading days after the plan’s big rollout the world discovered what Liability Driven Investments (LDIs) were.
Pension funds have long dated, defined liabilities, promising to pay pensioners a fixed stream of payments in the future. Pension fund managers purchase assets today that will hopefully generate enough income to meet those future liabilities. Therefore, when long dated interest rates fall, like they were doing for the last 14 years, it takes more investment today to meet the future liabilities. That can cause a pension fund to be “under-funded. It also causes pension funds to take a lot more risk which I am sure will cause a different problem shortly. However, lets deal with one nightmare at a time.
So, if you think about it, basic bond math is interest rates down, asset price up, interest rates up, asset price down. Because these are liabilities instead of assets (liabilities for the pension funds) just think the opposite of assets;
· Rates down, liability up - bad for pension fund managers,
· Rates up, liability down - good for pension fund managers.
To hedge themselves against falling interest rates, pension funds entered into LDIs with money managers like BlackRock and Schroders where the pension fund buys interest rate options that make money if interest rates fall and sells interest rate options that lose when rates go up. Essentially the pension funds are selling away some of their upside if rates go up (remember rates up, liability down, good for pension manager) to fund protection if rates fall. This is all great unless long dated interest rates go up over 100 basis points in one day, which is what happened.
Unfortunately, as the pension funds LDIs began to go horribly against them the money managers began making margin calls, big margin calls. Moreover, it has been rumored that the margin calls were the 24 hour kind. It is kind of interesting that firms like BlackRock were rumored to be freaking out with pension fund counterparties, treating them like a crypto hedge fund. Perhaps this gives us a window into how much stress the financial markets are really under.
Apparently by last Wednesday things in the Gilt market were becoming dire and the Pound-Sterling was trading like an emerging market currency in distress. The Bank of England stepped in and promised to buy at least 5 billion pounds worth of Gilts a day, every day until October 14th. A stated deadline like that is odd but it is probably the result of the BOE being furious that they were actually ready to start SELLING Gilts THIS WEEK to fight inflation. Now instead of Quantitative Tightening, they are back to Quantitative Easing. They probably planned the QT for 2 years and then right at the launch pad Liz Truss showed up.
Now the deadline is causing a problem. This week it was reported that Britain’s beleaguered pension funds have been selling billions of pounds worth of assets to build up cash reserves to meet future margin calls from their LDI counterparties. They are raising billions because without the BOE, all that stands between the UK and ruin is Liz Truss. And sure, enough the bleeding has started again as the 30-year Gilt dropped 5 points in price and rose 48 basis points in yield this week. Pound-Sterling has also begun to fall again, down 1.4% on Thursday.
Faced with simply returning to the same terrible place they were last Tuesday, the pension funds have been raising cash by selling U.S. Treasury bonds, corporate bonds and Collateralized Loan Obligations (CLOs). All else equal, large selling programs of U.S. bonds mean U.S. yields go up. That in turn effects everything from consumer loans to corporate and municipal debt borrowing rates here in the U.S. The selling has been painfully noticed and has begun to cause liquidity problems in our government bond markets. Unless the BOE rolls over the program past next Friday it is hard to believe global markets are going to have a lot of confidence in Gilts or Pound Sterling heading into next week. Big things are beginning to break.