The government’s mini-budget of September 23rd spooked the market. Pension funds were forced to sell gilts to cover a liquidity crunch, as their capacity to match their asset and liquid value collapsed in the face of high-interest rates and bond yields. With the author of that crisis (Kwasi Kwarteng) now sacked, and Jeremy Hunt assuming the role of chancellor, the government is attempting to course correct toward calmer seas. This volatility, which came close to rendering several pension funds insolvent, threatens to rear its head again once the Bank of England’s emergency intervention concludes this Friday.
The bond market
The government’s September mini-budget, variously described as a ‘fiscal event’ or a ‘cock-up’, sparked turmoil in the market. Facing a liquidity crisis, pension funds began to dump their holdings of government bonds, prompting the Bank of England to intervene with an emergency 13-day bond-buying programme.
On Wednesday, the Bank’s governor Andrew Bailey confirmed that its purchase of government bonds, or gilts, will have run its course by the 14th of October. However, he insisted it would support the market ‘in other ways’ beyond Friday. The announcement sent sterling, which had recovered against the dollar, tumbling again.
The markets have today been soothed by the Prime Minister, who has sacked Kwasi Kwarteng as chancellor and signalled a readiness to U-turn – again – on further measures contained in last month’s mini-budget. Though the markets are now more relaxed, at least until Monday, the broader financial landscape means these attempts to stabilise the economy likely mark the end of the beginning of the turbulence ahead.
Underlying this crisis is the wrongheaded assumption that interest rates and bond yields would remain low in perpetuity. The market for long-dated gilts was startled as the government’s promise of massive borrowing on the never-never signalled a lack of seriousness about paying down the national debt, and in turn, gilt yields shot up.
What does this mean for pensions?
This is particularly bad news for defined benefit pensions because they are the biggest buyers of government debt, with gilts making up £1.5trn of total UK pension fund assets. Owing to a bet-spreading practice known as LDI (liability-driven investment) funds match the value of their assets to their liquidity.
As bond yields soared, funds were faced with a liquid crunch. Being unable to raise the cash fast enough, they began selling their gilts thus increasing yields, and causing a catch-22.
The Bank of England managed to halt the so-called Doom Loop with the allocation of up to £5bn per day to be printed and then spent buying long-dated gilts. If this Doom Loop was permitted to spiral out of control, a number of pension funds would have defaulted, according to a letter from the Bank to the Parliament’s Treasury Committee.
This crisis has served to illustrate latent systemic risk associated with LDIs not dissimilar to derivatives in the run-up to 2008. The ubiquity of LDIs among pension funds means that the old maxim, when the US sneezes the world catches a cold – might be upended as contagion now threatens to travel West across the Atlantic. US firms are already posturing to fortify their position, with BlackRock amongst others announcing it was cutting leverage in its LDI funds and increasing liquidity.
US firms will enjoy some insulation due to their portfolios containing fewer fixed-income assets than their UK counterparts, making them more resilient to rate changes. But their use of LDIs, albeit in a not altogether identical way, and their exposure to more high-risk assets could make them a hostage to a downward trajectory in the market and cut away at their high yields.
What happens next?
Ironically quantitative easing has calmed a market spooked by the promises of unfunded tax cuts. If these measures of this sort continue to be leant on, there could be upwards pressure on inflation, and stress put on the political commitment to the triple lock.
At present, the government is bound to increase the state pension on the basis of whichever of; average earnings, inflation, or 2.5% is the greatest in the year. On present trends, the state pension could rise by as much as 10% by April of next year – but it’s unlikely that the guarantee can survive a great deal more rises of that sort.
The next stage of the government’s financial plan is set to be unveiled on the 31st of October, leaving investors to wonder whether they are in for trick or treat. As London pundits speculate the chances of Liz Truss being defenestrated by her own party within the next few weeks to be as high as 30%, and with the prospect of a Labour government looming large, there are few certainties in the near term. But, in Jeremy Hunt replacing Kwarteng as chancellor of the exchequer, there is an indication of a comprehensive abandonment of Liz Truss’s raison d’être, the so-called pro-growth agenda.