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Good morning. Yesterday, we avoided writing about the UK’s fiscal/financial/economic car crash, pleading that we were simple provincials focused on the American colonies. Readers wrote to say this was a dumb excuse for avoiding the biggest story in markets. We fold. Email us: robert.armstrong and ethan.wu.
Also, Monday will bring another collaborative edition of Unhedged, this time on Japan. We’re excited.
The mess in the UK
Financial journalists know that something has probably gone badly wrong when they have to learn a new acronym. This week it was LDI.
Liability-driven investing is a niche concept from the pension industry, of particular importance in the UK. But as much fun as it is to blame feckless pension managers or witless politicians, nothing about this week’s crackup is intrinsically pension-specific or British. It is exactly the type of event one expects at moments like this — at the end of a long bull market, with financial conditions tightening and growth slowing. So, lesson number one:
1. The LDI near-catastrophe was not a one-off
Here is what appears to have happened with pension funds and the gilt collapse this week:
Some big UK pension plans had a lot of long-term liabilities.
The plans didn’t have enough money to buy long-term government bonds that closely matched all their liabilities — because bond yields have been miserably low for years.
The plans therefore bought things with higher expected returns than bonds, such as equities.
This put the plans at risk for asset-liability mismatches. If interest rates fell — that is, if bond prices rose — the value of their liabilities will rise. Their equity (or whatever) assets might not rise at the same time, leaving them in a badly unfunded position on their next accounting statement.
So the plans signed derivative contracts, under which they would receive money from their counterparties when bond prices rose and pay money to those counterparties when bond prices fell. These were probably some flavour of receive-fixed pay-floating swaps.
A while later, UK chancellor Kwasi Kwarteng, dumped a petrol can of unfunded tax cuts on to the UK’s inflationary fire. UK gilt prices fall a lot. The plans now had to pay a lot of money.
To raise this money, the plans had to sell whatever’s handy. Gilts were one of the handy things.
Gilts fell more. More margin calls followed. More selling. Finally, the BoE was forced to intervene.
The key feature of this sorry tale is that some financial institutions had de facto or actual financial leverage that did not seem to be particularly risky to them, or to almost anyone else. This time around the leverage took the forms of those derivatives. They may have thought: what are the chances of gilt yields moving more than a full percentage point in a few days? Why, that’s a six-sigma event (or whatever)! Hidden leverage of this sort grows, like black mould in a basement, during long placid periods in markets. Low interest rates also provide a humid environment for financial fungi to grow. More floorboards will be ripped up, and more mould will be found, before this policy tightening cycle ends. Relatedly:
2. Stressed markets are non-linear markets
We learned in the great financial crisis that financial market outcomes are not normally distributed — not when it counts, anyway. The point was repeated in research reports, articles, books, movies and bumper stickers. But before long we all default to thinking in terms of average annual performance, standard deviations and so on. We just can’t help it. Well, friends, tail risk is back. How many UK investors were positioned for 30-year gilts to rise 121 basis points in three trading days? Investors who can’t handle high volatility — say, middle-aged journalists with big mortgages and twins who will be in college in a few years — should think about cutting risk now.
3. Central banks want to fight inflation, but they have other priorities, too
The Bank of England’s (temporary) resumption of bond-buying shows that the fight against inflation is conditional. It is stunning that the central bank would buy bonds with UK headline inflation at 10 per cent. It nodded to this awkward fact in a statement issued by the BoE financial policy committee (notably, not its Monetary Policy Committee):
Were dysfunction in [the long-dated gilt] market to continue or worsen, there would be a material risk to UK financial stability. This would lead to an unwarranted tightening of financing conditions and a reduction of the flow of credit to the real economy …
These purchases will be strictly time limited. They are intended to tackle a specific problem in the long-dated government bond market.
This mini-QE is supposed to last two weeks and, if it goes no further, the ultimate impact on UK inflation will probably be small. But if the gilt market remains unsteady, the BoE could end up removing monetary stimulus with one hand (through higher rates) while adding to it with the other (through bond-buying). In other words, the cost of stopping a financial meltdown is higher longer-term inflation risk. Relatedly:
4. Another developed economy is using yield curve control, or at least an impromptu version of it. Others could follow
By pinning down long rates while not backing down from further short rate increases, the BoE is dabbling in yield curve control. It hasn’t gone full Japan; there is no explicit long yield cap. But the move will revive the argument over whether YCC should be part of the central bank toolbox. Over at Free Lunch (subscribe here), the FT’s Martin Sandbu has made the case:
If financial markets are so sensitive to moves in longer-term government bonds, then why should central banks not focus more on controlling those rather than the short rates? We know two things. First, that if monetary policy controlled long yields, changing them gradually as the macroeconomic picture required, this week’s UK pension funds debacle would not have happened. Second, that central banks can choose to target long rates: the Bank of Japan has, for years, demonstrated how. Other central banks have adopted Japanese policies before. It seems time to consider doing so again.
This makes Unhedged nervous. True, Japan’s experience with YCC has not looked catastrophic. But Japan is Japan; its circumstances are sui generis. In a different context, might YCC, basically open-ended QE, drive private capital out of government bond markets and fuel speculative excess elsewhere? How much the unwinding of QE has frazzled US Treasury markets hints at another unappreciated risk: the process only works smoothly and predictably in one direction. Any unforeseen consequences may prove hard to undo.
5. End-of-an-era arguments just got a little stronger
Some people think that after the current inflationary incident is over, we will return to what was once called “the new normal”: low inflation, low growth, low rates, low volatility, high asset prices. Other people think that the pandemic only hastened the end of this pleasant economic regime. They argue it was doomed anyway, driven by demographics, global politics, the energy transition and huge accumulation of debt. Unhedged has written about this debate a number of times.
One leg of the fin-de-siècle argument is that, under demographic, political and financial pressure, governments will resort to fiscal as well as monetary excess, pushing inflation and rates up and asset prices down. The argument was articulated by Albert Edwards of Société Générale, with characteristic flourish, a few days before the Truss budget came out:
Until recently, economic ideology had prevented [politicians] breaking free from fiscal austerity. That had caused central bankers to fill the economic void with super-expansionary monetary policy. Those days are now over and aggressive fiscal activism reigns supreme, most visible currently in the UK. This will bring higher growth, higher inflation, and higher interest rates across the curve. The party for investors is over.
It is easy to laugh off the so-called perma-bears who have argued (for as much as a decade) that the post-financial crisis financial settlement was unsustainable and would end in tears: Edwards, John Hussman, Nouriel Roubini, Jeremy Grantham, and a few others. But if we do get a crash, they will be forgiven for being early. And the events in the UK this week fit nicely with their dreary prognostications. (Armstrong & Wu)
One good read
This is true.
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