The forty-five days in which prime minister Liz Truss was in office turned out to be the most disastrous days for the bond market in the last decades. In a matter of days Truss, together with Chancellor Kwasi Kwarteng, shacked up the financial markets with a new economic agenda known as “Trussonomics”. The agenda, was set around the idea that aggressive decreases in taxes and supply-side reforms were going to be able to solve the British economic malaise. Far away from its initial aim, “Trussonomics” and its by-product, the mini-budget, came to be one of the worst political errors in the recent history of advanced economies whose consequences were able to threaten the whole British economy.
The initial reactions to the mini-budget.
On the 23rd of September, the new British Government announced its new fiscal plan known as mini-budget with the aim to cushion the consequences of the increases in energy prices and boost economic growth. When it comes to the plan, the increase in expenditure amounted to £150 billion and the corporate tax cuts, the biggest in recent history, were expected to be at least £45 billion. Even if the fiscal path expected by the Government included falls in debt as a share of GDP in the medium term, markets were concerned about fiscal sustainability. Besides the size of the package, the reaction of the markets was also explained by the fact that the plan was announced by the government without any previous consultation with the Treasury, the Office for Budget Responsibility and the Bank of England (BoE).
When it comes to the effects of the plan, it did not take too long until the pound and the gilts[1] took a hit. Concerning the exchange rate, the depreciation of the pound was short-lived. After the first depreciation, it took less than a week for the pound to stabilized around the levels seen before the 23rd of September (Chart 1.a). Regarding the bond market, the mini-budget accelerated the upward trend in yields initiated around August 2022. From the 22nd of September up until the intervention of the BoE, the yields of gilts increased by around 50 basis points on average (Chart 1.b). When looking at the daily changes in yields of the 10-year gilts, the days following the announcement of the fiscal plan also coincided with the highest levels of volatility ever seen in the market (Chart 1.c).
From the monetary side, the time of the mini-budget could not have been worse for the BoE as the monetary authority was already in the middle of a hiking cycle complemented by Quantitative Tightening (QT) since February 2022[2].
The release of the fiscal package difficulted the work of the BoE in different ways. Starting from the timing, the mini-budget was announced on the 23rd of September, one day after the Monetary Policy Committee (MPC) established its last guidelines for the monetary policy stance. The release of the plan right after September´s MPC meant that the economic developments foreseen by the BoE and more specifically, the monetary policy stance, did not take into consideration the economic effects of the plan. Looking at the future evolution of the nominal rates, the reaction of the BoE, given the inflationary impact of the mini-budget, would have required more aggressive hikes. In this regard, the International Monetary Fund urged the UK to re-evaluate the economic consequences of the mini-budget. As declared by an IMF spokesperson on the 27th of September, “given the elevated inflation pressures in many countries, including the UK, we do not recommend large and untargeted fiscal packages at this juncture, as it is important that fiscal policy does not work at cross purposes to monetary policy”. From the side of the balance sheet policies, the situation was even more complicated as the disorderly bond market required a fast intervention. Although, since the BoE was already decreasing its balance sheet for several months, the purchase of gilts carried important risks for the credibility of the institution.
On top of the immediate problems triggered by the announcement of the mini-budget, some market participants started to react in reaction to the fast and unanticipated movements of yields. The financial intermediaries involved were the defined benefit (DB) pension schemes.
The pensions industry and the LDI strategies.
In order to find out how the DB schemes contributed to the market turmoil it is important to understand the Liability Driven Investment (LDI) strategies[3] followed by these market participants. In a general way, the LDI strategies allow pension schemes to reduce the risks associated with the changes in rates and inflation, aligning in a better way their assets/future liabilities[4] and reducing the volatility of funding deficits.
Concerning the origins of these strategies, pension funds started to use them back in 2002 as a response to the changes introduced in the accounting standards relative to the estimation of the present value of liabilities. Despite this, it was not until the aftermath of the Great Financial Crisis when pension schemes, due to the generalized decrease in interest rates, started to take into account more seriously the use of these strategies. As reported by the UK´s Investment Association, in 2021 the size of the LDI industry in the UK was close to £1.6 trillion.
When it comes to the practicalities of the LDI strategies, the way in which the present value of liabilities is estimated is a key element. In a situation in which a pension scheme does not use LDI strategies, a decrease in long-term rates increases the funding deficit as a consequence of the growth in the present value of the long-term liabilities. If, on the contrary, LDI strategies are used, decreasing yields allow schemes to withstand in a better way the increases in their long-term commitments as they can make a profit.
One typical way to apply LDI strategies is through the use of synthetic leverage coming from derivatives such as Interest Rate Swaps (IRS)[5]. In practical terms, IRS imply that a pension scheme receives a periodic flow of fixed interests in exchange for the payment of variable rates. While the fixed rates are calculated according to the future expectations of rates, the variable rates are determined by a short-term benchmark rate such as LIBOR and, more recently, SONIA. If yields decrease, the use of IRS turns out to be positive for pension schemes as the amount to be paid in variable interest rates is lower than the amount received from the counterparty. In this case, it is possible to say that the increases in long-term liabilities are offset by the cash gains coming from IRS.
If it is true that the cash obtained can be used to purchase “growth” assets[6], some pension schemes use it to increase their financial leverage. With the cash obtained, schemes purchase gilts to be used as collateral to borrow in the repo markets, with the final intention of increasing the purchase of gilts as well as “growth” assets.
Beyond the fiscal implications: leverage and the BoE’s “circuit breaker”.
As explained previously, the LDI strategies and the leverage that the pensions industry was creating were being sustained by the idea that rates were going to remain low or increase slowly and predictably. This situation was the one that characterized the years after the GFC and, to some extent, the first months of 2022. However, the fast movement of the gilts market in September completely changed this crucial assumption.
As soon as the yield of gilts started to increase, the margin calls derived from the IRS contracts started to put a strain on the liquidity positions of the DB schemes. As the value of the IRS contracts decreased, Central Counterparties (CCPs)[7] raised their variation margins as a consequence of the marked-to-market accounting standards. From the perspective of pension schemes, higher variation margins required them to post more collateral, normally in the form of cash.
The huge short-term liquidity needs faced completely wiped out the liquidity buffers of DB pension schemes and made them to draw on other sources of liquidity. While some pension schemes relied on the provision of more funds by DB´s investors (a process known as rebalancing) others, given the operational lags and the existence of large numbers of small investors in the case of the “pooled” LDI funds[8], had to sell “growth” assets as well as starting to deleverage in already illiquid markets[9]. As the majority of the collateral held by pension funds is in the form of long-term as well as inflation-linked gilts, a possible deleveraging through the fire sales of gilts would have led to more upward pressures for yields in the already stressed bond market. As a second-round effect, the large and concentrated positions on gilts of DBs would have led to feedback loops in which the schemes would have been forced to fire sell more assets as a consequence of the increased liquidity strains coming from the margin calls.
According to official sources, the BoE received some calls from LDI managers three days after the announcement of the mini-budget. In these calls, the LDI managers communicated to the monetary authority that further deteriorations in the bond market would force them to dump long-term gilts. According to BoE´s market intelligence, the amount to be sold was expected to be around £50 billion in the short term, in a market whose average daily trading of gilts was about £12 billion. Dumping in the market such a number of gilts would have been disastrous for the already deteriorated liquidity and depth of the gilts market.
In addition to the problems for the DB schemes, the situation had other risks for the British economy and financial system. When it comes to the general economy, the gilts market is, by far, the most important financial market of the British economy as it allows for the financing of government activities as well as for the implementation of some monetary policy operations. From the financial side, the importance of gilts is huge as they act as a pricing benchmark for other assets in the economy and financial institutions use them for collateral and regulatory purposes, as well as safe haven assets in times of stress. Moreover, a possible but unlikely widespread default of DB schemes would have led to problems for the CCPs behind the IRS contracts and, given the “default waterfall”, for the CCPs clearing members (i.e. systemic banks).
On the 28th of September, the disorderly conditions seen in the gilts marker forced the BoE to step in. With the intervention, the BoE became the market maker of last resort for the long dated-gilts for 13 days. Given the financial stability mandate, the operation was only aimed at restoring the orderly market, without having any implications on the decisions regarding QT. The maximum amount of gilts to be purchased daily was initially set to £5 billion although, this, as well as other terms of the intervention, could be changed at BoE´s discretion.
With the intervention, the BoE was introducing a “circuit breaker” in the system aimed to reduce the self-reinforcing falls in gilts prices, the risk premium associated with the run dynamics as well as the risk of contagion to other financial intermediaries and the general credit conditions. The operation was conducted through the secondary market and was designed to pump liquidity in “all the cracks” as it was directed to pension schemes, skipping the normal banking intermediaries used by the central banks. In addition to the announcement, the BoE repeatedly stressed that the intervention was a crisis-driven reaction that was not unwinding its QT efforts. The operation was also framed as a measure that was not coordinated with the most recent fiscal developments coming from Downing Street. When it comes to the exit path, the purchases of gilts were supposed to be abandoned in an orderly fashion once the risk to market dysfunction was judged to be subdued.
Even though the first positive reaction of the markets, the effects of the announcement started to fade away some days after the intervention. (see Chart 1.b). One of the possible reasons of this was the slow pace at which the BoE was purchasing gilts. When comparing the number of purchased gilts with the £5 billion announced, it is clear that the BoE did not make full use of the maximum daily amounts allowed (Chart 2). This decision can be explained by the existence of moral hazard and the BoE´s intentions of not creating a benign environment with low yields. In this light, the monetary authority wanted to exert some pressure on LDI funds to rebalance their portfolios and get cash and liquid collateral from other sources in order to avoid the creation of a cliff hedge at the end day of the intervention.
On the 10th of October the BoE announced further interventions. Given the still shaky situation of LDI funds, the BoE decided to increase the firepower of the daily auctions up to £10 billion, including index-linked gilts from the 11th of October, and launch a complementary[10] liquidity facility, the Temporary Expanded Collateral Repo Facility (TECRF), expiring on the 10th of November. Through this facility, banks were supposed to channel liquidity to LDI funds in more favorable terms. In order to do so, banks were able to get more liquidity from the BoE as they were allowed to post index-linked gilts and some corporate bonds[11] as collateral.
The second intervention of the BoE was also explained by the fact that around the 10th of October the LDI funds reported that, as the amount of capital that they were able to raise was insufficient to cover all the liquidity demands, they were planning to liquidate non-liquid assets such as index-linked gilts, sterling and corporate bonds. Together with this, the BoE also anticipated that the operational lags in the portfolio rebalancing processes of the funds were likely to concentrate the liquidation of gilts around the 14th of October, the end date of the temporary intervention.
Concerning the exit strategy, the BoE established a differentiation between the sales of gilts purchased for financial stability reasons and those bought during the Quantitative Easing (QE) years. When it comes to the gilts purchased as a consequence of the mini-budget shock, the amounts sold have been dependent on the market appetite, instead of being determined by predefined targets. The strategy that was used followed a demand-led approach in which the number of gilts sold was completely discretionary and dependent on the market and demand conditions. In order to reduce the possible negative repercussions, the BoE also set a minimum level of prices to accept.
Regarding the state of the gilts market as well as the situation of the LDI funds after the £19.3 billion intervention of the BoE, it is possible to say that the actions undertaken by the monetary authority mitigated the economic and financial consequences of the mini-budget. When it comes to the shock in the gilts market the actions of the BoE forced LDI funds and DB pension schemes to cover the liquidity necessities and to increase their levels of capital, reducing the risk of self-reinforcing fire sales dynamics[12]. Concerning the effects on the gilts yield, the interventions of the BoE were able to reassure the markets with any negative effect on the credibility of the monetary authority. This last point about credibility is important because of the time at which the mini-budget shock took place. If it is true that other major central banks have conducted targeted interventions in certain segments of the market before, any of them intervened in the middle of a tightening period. The BoE was able to calm the markets without any change in its monetary policy stance, as determined by the subsequent rate hikes and the continuation of QT.
Despite the performance of the BoE, it must be clear that the market turmoil affecting the gilts market could not have been reversed completely without fixing the root cause of the problem in the first place, the unsustainable path of the UK public finances as a consequence of the mini-budget. The BoE was only able to reverse the negative bond market dynamics triggered by an excessive accumulation of leverage in some parts of the pensions industry.
From the political side, the mini budget’s collision with economic reality forced Truss to step down as prime minister and somehow predefined the fiscal policy stance of Rishi Sunak´s new government. When it comes to the question of whether this situation could have been averted, one prominent voice in financial markets once said that it is not possible to find out who’s been swimming naked until the tide goes out. As recent history has shown, periods of ample liquidity tend to be followed by negative financial events that unfold very rapidly. In the context of the LDI funds some market participants already warned about the effects on liquidity that large increases in rates and margin calls could have. In the international sphere, the problems arising from the liquidity strains of non-banking financial intermediaries as a consequence of the sudden increases in margin calls are well known[13]. Even if the post-2008 regulatory reforms regarding derivatives and clearing proved to be positive to reduce the financial stability risks and badly managed counterparty exposures, the margining practices constitute one of the weak points of the regulatory landscape. In this regard the international standard setters conducted a review of the margining practices for centrally and non-centrally cleared markets in order to improve the transparency of these practices, the predictability of the margin calls as well as the preparedness of market participants. When it comes to the possibilities of other jurisdictions facing the problems associated with excessive levels of leverage, the Bank of International Settlements (BIS) recently reported that the risks in the defined benefit pension systems coming from a huge repricing of public debt are much more unlikely as a consequence of the lower reliance on leverage, among others.
On the regulatory side, The Pensions Regulator (TPR) guidance acknowledged the possible risks for DB schemes coming from leverage and the management of collateral in 2017. Additionally, one year later, the Financial Policy Committee (FPC) checked the capacity of the pension schemes to cover the positioning of variation margin calls on over-the-counter (OTC) interest rate derivatives under a scenario in which there was a sudden 100 bp. increase in rates across all maturities and currencies. According to Andrew Bailey, “the results suggested that pension funds would be resilient to a severe but plausible shock of that magnitude. However, (…) it was not clear whether pension funds pay sufficient attention to liquidity risks”. The assessment conducted by the FPC also highlighted the need to monitor the risks associated with the use of leverage by LDI funds but despite this, any new requirements were established by the regulators[14] of DB pension schemes and LDI funds. That same year, the BoE Financial Stability Report concluded that the IRS exposures of the schemes were around £900 billion, much more than any other non-banking intermediary. In light of this and, under some assumptions, some analysts estimated that the losses derived from negative market moves would be close to £1 billion for every basis point increase in yields.
Conclusion.
As seen, the announcement of the mini-budget as well as the sudden appearance of some pockets of (nearly)hidden leverage were able to shake the bond market putting an end to the government of Liz Truss in a matter of days.
Apart from the political lessons, the situation faced by the British economy was also relevant to other central banks as it created some sort of guidelines about how to act when the two main mandates of the monetary authority are, clearly, in conflict. In the current context of high inflation, the appearance of market disruptions would require the central bank to intervene in ways that, if sustained, can be counterproductive for the price stability mandate. While inflation requires to increase interest rates and tighten financial conditions, the disruptions in the bond market call for a forceful intervention aimed to pump liquidity into the system. The surgical intervention of the BoE showed that sudden market disruptions can be properly addressed with temporary and well-communicated actions.
[1] As some analysts argued, when compared with other historical events the first effects of the mini-budget in the financial markets coincided with a classic balance of payment crisis, normally attributed to developing economies. In this regard, it is important to mention that when compared with developing economies, the British economy as well as the reserve currency status of the pound created a completely different situation.
[2] The QT policies of the BoE started in February after the cease in the reimbursement of maturing assets. In August, the BoE announced that on the 3rd of October they were going to start with the selling of assets.
[3] In the context of LDI strategies some analysts distinguish between non-leveraged and leveraged LDI. In this article, all the references to LDI strategies imply the use of leverage.
[4] These correspond to the projected future benefits to be paid from the scheme.
[5] Derivatives can be defined as assets whose value over time depends on the performance of an underlying asset. When it comes to IRS, these are derivatives through which two counterparts exchange periodic flows derived from interest rates.
[6] “Growth” assets can be understood as return-seeking investments.
[7] The CCPs are financial intermediaries that act as a seller for every buyer and as a buyer for every seller in some financial transactions. In practical terms, CCPs diminish the contagion risks among counterparties as they guarantee the payments and the exchange of assets (settlement) in all the transactions in which they are involved. When it comes to over-the-counter derivative markets, mandatory central clearing was introduced after the Great Financial Crisis. For a deeper analysis of the role of CCPs, see April 2010´s Financial Stability Report.
[8] The “pooled” LDI funds allow small DBs to get access to the LDI strategies through asset managers. According to some of the estimations of the BoE the size of “pooled” funds in September was around 10 to 15 percent of the whole LDI market. When compared to normal LDI funds, the “pooled” funds have limited liabilities and capacity to face losses.
[9] Some market commentators also pointed to the LDI funds using corporate bonds to meet the collateral demands as well as setting up collateral transformation facilities with banks.
[10] Together with the TECRF, the BoE had in place other liquidity facilities: the Indexed Long-Term Repo, the Short-Term Repo Facility as well as the Discount Window Facility.
[11] The quality of the accepted was equivalent to Baa3/BBB- or above.
[14] When it comes to regulators, The Pensions Regulator (TPR) and the Financial Conduct Authority (FCA) are in charge of regulating DB pension schemes and LDI funds, based inside the UK, respectively.
