What caught my eye this week.
Last week we debated the Mini Budget on Monevator in a couple of excellent threads of reader comments.
By Wednesday morning all that was out the window.
Any potential benefits to the new administration signalling a growth agenda or to its seemingly ill-timed tax cuts were moot. The gamble had already backfired.
The UK government bond (gilt) market was in meltdown.
Most of the headlines had focused on the weakness of the pound following Kwasi Kwarteng’s bolt from very blue.
But the impact on the gilt market was soon apparent.
Indeed as the week began I was tinkering with my ‘low volatility’ sub-portfolio I’d set up specifically to feel safer in what looked like being a choppy 2022.
Longer duration bonds – and a few proxies such as REITs – were sliding.
Time to nip and tuck?
But by Wednesday morning, my now ironically-named low-volatility basket was shedding value like sheets of snow slewing off a roof in the warming sun.
This was not supposed to happen – at this pace – with government bonds:
https://twitter.com/Monevator/status/1575034713869553664
It looked to me like forced selling and I doubted it could stand for long.
Was it, then, a chance to load up?
I was on the scent – pension funds were in difficulties. But my learning curve – and the slope the descent – was too steep for me to get confident about a wholesale switch into these supposedly super-safe assets. How bad would it get?
Then – even as I was giving myself a crash course in the ‘liability driven investment’ (LDI) hedging strategies behind the plunge – I saw the same index-linked gilt ETF was climbing.
Was I missing the boat? Had big investors stepped in?
Now it was motoring! The sheer pace made it clear I’d missed a ‘red headline’ on a Bloomberg.
So there I was just before lunchtime on Wednesday, when the Bank of England stepped in to save the pensions sector from imploding.
Where were you?
The doom loop
Like always with these events – from the Global Financial Crisis to September 11 to Pearl Harbour – there’s a paper trail you can follow with hindsight, after the worst has happened.
It turns out insiders had warned about the potential risk of a spiraling LDI crisis months ago.
For example, from the Financial Times in July:
LDI is big business, having more than tripled in size over the past decade, and the reason is simple — it helps funds manage the risks in meeting their pension promises for members, partly through derivatives.
But now funds are facing calls from counterparties to put up collateral to fund those trades. The sums are potentially huge and asset sales to meet the calls could have a knock-on effect to markets such as equities.
Of course nobody paid much attention.
UK politics has been quietly mullering the economy for years, but it hadn’t yet crystalized in a drama that stood apart from the fug of lockdown. The damage was real, but diffuse enough to dismiss pre-Brexit concerns as scaremongering. Yields were rising, but that was a global thing.
But this time was different. What Rishi Sunak had warned would happen in his debates with Liz Truss had started before Kwasi Kwarteng had barely stopped talking.
Confidence was shot, and investors started to mark down British assets.
And through the hedging strategies of pension funds, there was a mechanism for shit to get real, quickly.
You’ve probably had your fill of explainers over the past few days. This was one of those weeks where our little corner of the Internet becomes front page news. (Honestly, it never happens if Egyptology is your hobby.)
But in short: in less febrile times pension funds hedged away the risk of prices moving against them – and impacting their ability to fund their liabilities – with derivatives. These hedges were backed with collateral, including but not limited to gilts. As gilt prices fell they triggered margin calls, which to some currently unknown extent prompted more gilt selling. That drove gilt prices lower. Causing more margin calls. You get the picture.
I haven’t seen anyone else make the comparison yet, but what this most reminds me of is the 1987 stock market crash.
That year’s short, sharp plunge was blamed on portfolio insurance strategies. Again they were meant to protect against declines that they were afterwards blamed for accelerating.
Of course the 1987 crash was in equities – where we’re all ready to shrug our shoulders and say it happens.
Not in the ‘safe’ gilt market, which is meant to be the bedrock of the financial system.
We’re all in it together
Yet for all the drama of a highly-rated government bond market in meltdown, even a crash of this magnitude is not truly surprising to me.
As long-term readers know – and have suffered – like others I’ve been warning about the political direction of travel in the UK for years. That it’s finally culminated in something like this is arguably a feature not a bug of the narrative’s fairy tale thinking, to borrow Sunak’s phrase.
Even for markets generally, it’s almost surprising it took so long for something to really break given the regime change of 2020.
As I wrote in April when high inflation had started to cause ructions in student loans:
I’m surprised we haven’t heard about massive financial blow-ups yet, given the pace of developments.
Another one ticked off the To Do list.
I also warned about quantitative tightening back in February, of the likely hit to retirement plans, and urged readers to stress test their mortgages even as others celebrated a return to double-digit house price inflation.
I’d argue Monevator was ahead of the curve on all that. Yet a fat lot of good it’s done me personally, so fast have things gone off the rails.
Hitherto you could kind of wave away the cost-of-living crisis if you had sufficient funds to put the heating on without a care and to do your weekly shop at Waitrose.
It was awful, of course, to imagine families on the breadline without the money to heat their homes.
But you wouldn’t be personally much at risk.
Now though the realities of 2022 are becoming manifest for all of us.
Keep calm and carry on cutting
How will this all resolve itself in the weeks and months ahead?
Your guess is as good as mine.
But for starters, I suspect the pound ended the week strengthening not because the markets are suddenly smitten with Trussonomics – as the reliably-ludicrous John Redwood claimed on Twitter.
Rather, traders surely sense that – with Labour more than 30 points ahead in the polls and Tory backbenchers up in arms – we’ll see a personnel change and/or a row-back of policy.
Or, more frighteningly, an enormous axe taken to already-straitened State provisions.
As I said last week, I’ve nothing against lower taxes or even an aspiration to shrink the State, in principle. A long time ago I even voted Conservative once or twice.
I also agree Britain has a long-term productivity problem – plus now the self-inflicted wounds of leaving the EU. (Trade frictions, staff issues, higher inflation, and so on).
But even with a sympathetic read, the Mini Budget seemed to have its priorities mostly wrong. Especially with the relatively cheap but politically toxic scrapping of the 45% rate of tax.
One day, sure. But why now?
Meanwhile talk of supposedly game-changing supply-side reforms are just talk until November.
Add to the Budget surprises the government’s high-handed treatment of everyone from the civil service to the OBR to the Bank of England to the media, it’s not surprising investors took flight.
Something must be done to calm things a longer-term basis. Otherwise borrowing costs will go haywire, provoking a truly deep recession and making the UK’s debt burden a noose.
Just keep in mind that to reassure the gilt market, Truss and crew only need to show they understand Britain’s particular economic problems – especially its big trade deficits – and that Britain will pay its bills in a vaguely inflation-sensitive fashion.
The market doesn’t really need to care whether Truss and Kwarteng have a palatable project in mind.
Gilts trade in a financial market. They are not tallied up on a morality-weighing machine.
Which means a calming resolution here might be as ugly as the cause, for many people.
There’s talk, for instance, Truss could cut benefits in real terms to help balance the nation’s books.
More pain, more gain
Perhaps hard-right Tories would see bringing fire and brimstone to the welfare state as making the best of a crisis.
Time will tell.
However in the same vein of looking for a bright side in a car crash, I want to conclude by stressing there’s a silver lining to this bond market roiling.
I’ve been surprised recently how often people here and elsewhere are asking whether they should now dump their bonds.
I’d say that boat has sailed. On the contrary, from here on bonds may regain their place as a useful portfolio diversifier.
Because while bond prices have fallen further and faster than almost anyone anticipated – at least until the Bank of England stepped in – that has in turn driven up yields for new purchasers.
Clearly it’s easier for me to say this as a naughty active investor who came into 2022 with zero in gilts or Treasuries. (I have had swingeing losses on what I bought this year though, so do share some pain!)
But in the long-term, higher returns than they otherwise could have expected – at least compared to what were at worst nailed-on negative yields – will hold be for passive investors, too.
Lower bond prices are – eventually – beneficial to bond fund returns. Bonds will rollover and the money is reinvested into higher-yielding issues. These deliver more income bang for your buck in future years.
Again, this sea-change has been fast and dramatic.
The 30-year index linked gilt yield-to-maturity (YTM), for example, was negative 2% in December 2020. You were paying the government to inflation-protect your capital.
But the sell-off sent its yield above 2%. You could lock in a 2% real return if you wanted.
That seems attractive right now. Will it amount to much in the years ahead? As ever we cannot know. But it’s certain that positively growing wealth is a lot better for your portfolio than an asset priced to eat it.
It’s a similarly remarkable story with the 10-year vanilla gilt yield:
We are back to pre-2010 levels here.
Again, 4.1% doesn’t seem amazingly attractive with inflation running near-10%, but that shouldn’t last. Moreover there’s now some yield firepower to buffer a portfolio again, should equities fall.
And the 10-year gilt yield was as high as 4.5% before the Bank of England intervention.
It ain’t over until it’s over
Incidentally, some people say the Bank is back to QE in trying to manage down longer-term yields.
I believe that’s wide of the mark.
The Bank of England has said its gilt buying is a temporary measure designed to restore market functioning. It’s even put a date on stopping the purchases.
To me the Bank clearly aspires to get pension funds enough time to fix their positions and then to let gilt yields go where they may.
And when that happens, prices could resume their fall, and yields climb again. Which would price fixed rate mortgages even higher, among other things.
Of course the Bank may be overtaken by events again. But the point is the same push-me pull-you dynamic that I cited last week (and that The Sunday Times paid, um, homage to) is still in place.
The Bank of England wants to raise rates to curb inflation. Meanwhile the government (so far) has only announced extra borrowing and tax cuts.
The first tightens money. The second is loose. Something has already given. There’ll surely be more drama to come.
A few follow-up reads:
- Seven days that shook the UK [Search result] – FT
- Who exactly has the BoE bailed out? [Search result] – FT
- “I’d never seen anything like it”: market turmoil sparked a pension sell-off – Guardian
- The liquidity haves and have nots – Bond Vigilantes
Oh and while this week’s acute crisis was of the government’s own making, it’s true that the sell-off in bonds in 2022 has been historic globally:
That’s a lot of pain to go around.
It’s all go
Lastly, a housekeeping note.
Readers who peruse Monevator via mobile may have found they couldn’t read our new passive investing guide on their phones this week.
The special mobile theme that we were using didn’t render the page properly.
That theme delivered a lovely browsing experience on mobile and I know some of you loved it. But it has been causing problems for years now.
So we’ve decided to turn it off. Instead, the standard responsive Monevator theme will now load across all devices.
Sorry if you regret the change. But please do check out the passive investing guide – and forward it to your family and friends! It’s really comprehensive.
Have a great weekend everyone.
