“Only when the tide goes out that you discover who’s been swimming naked.”
This statement has been around so long it almost makes me cringe to use it. It’s attributed to Warren Buffett, but who really knows for sure? I don’t remember what I had for lunch yesterday, so I’m sure he doesn’t know if he came up with the statement on his own or heard it somewhere back in the mists of time.
But the spirit of the comment sure captures this week’s events. Sure, there was some pertinent economic data. Probably top of the list was the release of the Fed’s preferred inflation gauge. The Personal Consumption Expenditures Price Index (PCE) was up +6.2% in August versus expectations for a +6.0% gain. The month-over-month change was +0.3% versus +0.1% expected.
But investors were much more focused on the latest gyrations in U.K bond yields and what it might mean for other dark, shadowy parts of the financial markets.
Prices Moved Enough to Break Something
Last week we touched on the dramatic move in both U.K. bond yields and the British pound. The chart below highlights this.
When you get a big move in the price of something you always wonder who is on the other side of the trade? When AMC went vertical last year, some hedge funds were on the other side of the trade and lost a bucket load of money. Hard to feel very sorry for them of course – life goes on, and the failure of a single fund rarely has much broader implications.
But the recent spike in U.K. yields was enough to break something and trigger a bailout by the Bank of England (BoE) on Wednesday. The central bank warned of a “material risk to UK financial stability” from turmoil in the UK government bond market. The word ‘Lehman’ was thrown around. That can’t be good.
The move by the BoE was all the more amazing because only a few days prior they were talking of their commitment to quantitative tightening (QT) – that is selling bonds to drain liquidity from the banking system. Now they were doing the exact opposite!! Not exactly confidence inspiring, especially after the derision the new government’s budget was greeted with last Friday.
A Multi-Standard Deviation Move – Or This Isn’t Meant to Happen
The move in U.K. bond prices is really unprecedented. Before the BoE stepped in the price of the 30-year gilt fell by -24% in four trading days. Once the BoE intervened that same bond soared +24%. Remember, this isn’t a penny stock, this is the price of a bond of a major developed country!!
What’s going on?
Basically, the tide went out (bond prices went down in price) and we found out that some large investors were over leveraged. It’s a story as old as time.
In every financial panic there’s a villain. During the 1987 crash it was a product called Portfolio Insurance. In the GFC it was mortgage CDO’s and variations on the theme. In this case the offending instrument is called a Liability Driven Investment (LDI) strategy. Never heard of it? Join the club. Rather than getting into the weeds, the basic premise is as follows:
- Pension plans in the U.K., like pension plans around the world, invest in an assortment of assets to meet future commitments. They will hold bonds, stocks, real estate, etc.
- Pension accounting is a funny thing. As interest rates fall, the value of future commitments go up, at least on an accounting basis.
- So, if you are running a pension, you are worried about a lot of things, but in particular, you are worried about falling interest rates inflating the value of future liabilities while your ability to invest in high yielding instruments disappears.
- Capitalism being capitalism, it sees a problem and finds a solution. Hence, the advent of the LDI strategy. Basically, U.K. pension plans bought bonds in a leveraged manner through derivative instruments to hedge against falling rates.
- Being a derivative meant the pensions didn’t have to pay the full price upfront, they just posted collateral (margin).
- Upside of this is they didn’t have to tie up precious capital buying an asset. Bad news is they bought a leveraged asset and were committed to posting more collateral if prices went down.
- Well, prices went down. In this case bond prices (see the chart above – the down -24% part of the chart). Pensions had to post more collateral, and as it turns out, they didn’t have any ready cash. As a result, they were forced into selling other assets to meet margin calls.
- What do they sell? Well, in many cases it’s the bonds that are going down in value, which creates something of a doom loop. Bond prices goes down – pension gets a margin call – pension has to sell the same bonds that have gone down in value – pension gets an even bigger margin call. Rinse repeat.
Now if LDI was a niche business no one would care. But just in the UK they represent about £1.5tn of assets, which is about two-thirds of the UK’s GDP, or the size of the entire gilt market. They’re huge, in other words. Hence the following quote from the FT earlier in the week:
Now the Lehman comment might be going too far at the moment. What we appear to have is a liquidity problem. Pensions didn’t have enough cash on hand and so were being forced to liquidate into a falling market. Not fun, but the pensions aren’t on the cusp of failing (a so-called solvency crisis). Why? When banks or funds fail it’s generally because depositors or investors pull they money from the problem child or funding dries up. You can’t have a ‘run on the bank’ at a pension.
The pensions in question have plenty of assets to cover the margin calls, but the market was broken. Enter the central bank. Central banks were created as lenders of last resort. Think back to the panic of 1907 – the markets were plummeting, life savings were being wiped out, and J.P. Morgan rode to the rescue by writing a big check.
Well, smart minds realized that this wasn’t a sustainable strategy, so enter central bankers to act as the writer of the big check. This is exactly what the BoE was created to do and exactly what they did. They saw a liquidity crisis in the making and stepped in to stabilize things.
All well and good. U.K. bond yields came down, the pound stabilized, and the pension funds were presumably able to get their affairs in order. But more structural questions remain unanswered for the U.K.:
- How long will this intervention last?
- The BoE is providing support/stimulus at the same time inflation is a problem. Can they raise rates at the same time they are buying unlimited amounts of long-term bonds?
- What’s it all mean for inflation and central bank credibility?
We don’t know the answers, at least not yet. U.K. pension plan managers have clearly been caught swimming naked. Does an ‘emperor has no clothes moment’ await the British central bank? Time will tell.
Charts We Found Interesting
- The price of sterling going back to 1791. The rally in 1864 was due to capital fleeing the U.S. due to the Civil War. Been downhill ever since.
- Generally, when a topic makes the cover of The Economist it is time to bet against the prevailing narrative. In this case, you might argue the cover is too optimistic because it gave Chancellor Kwarteng a paddle.
- Mortgage rates are quickly pushing towards 7% in the U.S.