Commentary on Political Economy

Monday 24 October 2022


A shock to the global system from UK’s gilt market ‘episode’

The UK’s great gift to the world through its very British omnicrisis of the past month – beyond the comedy value and schadenfreude – is to provide a useful reminder that in markets, things can fall apart quickly with grim real-world consequences.

Some politicians have sought to blame the wild scenes in sterling and, more importantly, in gilts on global factors as if the toxic ‘‘mini’’ budget played only a bit part. This notion is for the birds.

But one thread of this thinking does make sense, which is that the market impact of former chancellor Kwasi Kwarteng’s doomed fiscal plans was faster and deeper than it otherwise needed to be. This was for two reasons.

One is that bond markets are creaking at the seams under the pressure of rapid interest rate rises and soaring inflation. The other is leverage, which has flourished in the long era of low, dull interest rates but can backfire quickly when the environment changes.

In the case of the ‘‘mini’’ budget – now presumably a ‘‘nano’’ budget since many of its key elements got scrubbed – bond investors found the fiscal plans so objectionable, and so cavalier in their presentation, that prices fell unusually fast.

That was bad enough. Where it went really wrong, though, is that this sell-off stumbled on to a landmine stuffed with derivatives – the strategies employed by pension funds to hedge against inflation and interest rate risk.

No one had ever thought to stress-test these boringly named liability-driven investment (LDI) strategies for a scenario where gilt yields add a full percentage point in a day, because why would you? That had never happened before.

Well, now it has, and we can see how this pushed the entire gilt market to the edge.

So, could this happen again anywhere else? To paraphrase, the answer from Bank of America is, ‘‘well, duh, obviously’’.

‘‘Of course something will break, what else did you expect?’’ wrote Athanasios Vamvakidis and Adarsh Sinha at the bank. To their mind, all this hand-wringing over what else could go wrong in the style of UK LDI is wide of the mark. ‘‘Something has already broken,’’ they wrote. ‘‘Inflation.’’

The scary thing is that like LDI, other innocuous-sounding products that made perfect sense while interest rates were low are tucked away in unpredictable places. Now that interest rates are rising fast in response to sky-high inflation, more of these landmines are at risk of going off.

This is an increasingly pressing concern. Max Kettner, chief multi-asset strategist at HSBC, noted that one of the key reasons why 2023 might turn out to be just as challenging as 2022 for investors is the risk that, as he put it, ‘‘something breaks’’.

‘‘Given the record amount of tightening of financial conditions, the risk of an accident in financial markets has greatly increased,’’ he wrote.

‘‘Whether it’s the recent turmoil in the UK, the relentless weakening of the yen, deteriorating liquidity on credit and even rates markets, defaults in emerging markets, or indeed something we’re completely missing the list has become longer in recent months.’’

Trying to pinpoint what could unravel is a fool’s errand. The whole point of shocks is that you don’t expect them or know where they come from. The good news is that authorities have sat up and taken notice.

Sir Jon Cunliffe, the Bank of England’s deputy governor for financial stability, noted this week that the ‘‘episode in the gilt market’’ had sharpened the focus on the need to monitor and regulate non-bank financial institutions.

Elsewhere, nobody wants a repeat of the horror show in the UK on their turf. In the Netherlands, which has a retirement system with some similarities to the UK’s, authorities have urged pension funds to consider boosting holdings of liquid assets in case of a UK-style shock.

And fund managers are now considering risks that a few months ago would have been considered fanciful. What if, for whatever reason, the US Treasuries market one day flips out like gilts did? Price moves in the US have, after all, been alarmingly large and abrupt of late.

What would happen to Asian investors if the Bank of Japan abandoned its bond-buying policy and yields there exploded higher? Which other bits of the shadow banking system are primed for an implosion?

The problem is that it may be too late to defuse the risks.

‘‘The time was when central banks were easing policies aggressively in the previous decades of the low inflation era, to reach an inflation target beyond their reach,’’ BofA said. ‘‘Instead, an economy with asset price bubbles was created, addicted to zero interest rates, ample liquidity and the [support of] central banks.’’

August institutions like the Bank for International Settlements warned repeatedly about the dangers of hidden leverage, it added.

‘‘In this context, why were UK pension funds allowed to get into such super-leveraged investments to begin with?’’ It is a good but pointless question. What matters now is being alert, and checking assumptions.

The government bond markets that underpin derivatives and other asset prices globally simply do not behave like they used to.

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