Needed Context for the BoE’s Poor Word Choice

Contagion. That is the word many pundits latched onto Monday, when the Bank of England (BoE) announced new support measures for pensions forced to sell Gilts to meet sudden margin calls. When the trouble first erupted two weeks ago, a vicious circle of rising interest rates and forced selling prompted the BoE to offer to step in as Gilt buyer of last resort for pensions to stop this technical issue from roiling broader markets. That stemmed the tide for a while, but another 10-year yield spike Monday to a fresh closing high of 4.55% accompanied more intervention to “reduce risks from contagion.”^[i] There is a lot more to that sentence, as we will discuss, but much of the coverage buried the context, and the hunt for the next shoe to drop began. We aren’t dismissing the UK bond market ructions, but we don’t think this is a 2008-scale financial crisis in waiting.

For simplicity, we will avoid rehashing the political backdrop other than to say yields initially spiked when the market overreacted to the new government’s “mini-budget” that attempted to offset a stealth tax increase with tiny tax rate cuts. For our purposes today, it simply matters that when long rates jumped, it triggered some problems in a corner of the UK pensions market called Liability-Driven Investing (LDI), which—as the name implies—is a tactic pensions will use to match their investments with their future liabilities. In practice, this is easier said than done, as some active pensions have unfunded liabilities, meaning they are still accepting new participants, don’t know what their actual benefits payments will be and still need to earn a long-term return to be able to pay benefits to all participants. As a result, many funds will invest in stocks and other securities as well as bonds, which earns the needed return over time but also subjects the pension’s total value to market volatility in the interim. Enter LDI, which uses interest rate swaps and other derivatives to hedge against market movement in order to keep a portfolio’s market value (and funding ratio) more stable when volatility strikes.

We won’t get into the technicalities of all these contracts, as that too is beside the general point. All you need to know is that a lot of funds used LDI to get leveraged exposure to fixed income in order to increase returns when yields were low. The derivative contracts were designed to rise in value when interest rates fall, but when rates rise and values fall, it requires pensions to post more collateral to meet their margin requirements.

Usually bond markets have relatively low expected volatility, which gives the funds time to pick and choose how to raise collateral in the least disruptive manner possible. But Gilt yields’ sudden rise shortened the clock, leading pensions to take the easiest route possible and sell them. That sent yields higher, increasing collateral calls, forcing more selling, lather, rinse, repeat until the BoE stepped in two weeks ago Wednesday, offering to buy up to £65 billion in Gilts from pensions.

Initially that seemed to help. Gilt yields settled back down. But concerns didn’t fade since the BoE’s support had an expiration date of October 14, triggering fears that the bank had merely kicked the can and delayed the reckoning. 10-year Gilt yields crept back up, closing at 4.23% last Friday—just 9 basis points below their pre-intervention high of 4.32% on September 27.^[ii]

So the BoE made some adjustments. Initially, it offered to buy up to £5 billion bonds daily for a total of £65 billion. But of the £40 billion offered so far, funds have taken only £5 billion—ostensibly a sign the industry doesn’t need as much firepower as the BoE has offered.^[iii] In our view, that is a positive sign, an indication pension funds aren’t reliant on BoE support. But the BoE decided to handle this by upping its daily tender offer to £10 billion in hopes of deploying close to the full allotment before the program expires. It also introduced a new vehicle, the Temporary Expanded Collateral Repo Facility (TECRF), which will let pension funds use their banks as a proxy to park corporate and government bonds at the BoE for 30 days in exchange for cash. They can use this cash to meet immediate collateral requirements to buy more time to raise permanent funding without dumping Gilts at bargain basement prices. That program runs through November 10, but the BoE will continue offering banks liquidity through its permanent repo facilities, and its communique is clear that it expects banks will use this to assist pension funds with their liquidity needs. Lastly, on Tuesday, the BoE upped its Gilt purchase allotment to £20 billion and widened the program to inflation-linked bonds, which have also sold off lately.

Our opinion on this is rather mixed. On the positive side, we think Gilt yields’ spike is part of a sentiment-fueled global move and unlikely to last, so we don’t think the BoE is putting a small bandage on a gaping wound. It appears to be applying one of the biggest lessons learned in 2008, which is that extending temporary cash to entities that are illiquid but solvent can help prevent collapses and forced selling, basically bridging the gap until sentiment improves. But theory doesn’t always square with reality. Whenever central banks come at these problems with an alphabet soup of temporary measures, it can foment fear, as it creates the perception of systemic issues requiring emergency support. In our view, the Fed’s laundry list of assistance measures in 2020 had this effect, and the BoE’s latest move appeared to do the same yesterday.

Using the word “contagion” probably didn’t help. Here is what the BoE actually said: “Against the backdrop of an unprecedented repricing in UK assets, the Bank announced a temporary and targeted intervention on Wednesday 28 September to restore market functioning in long-dated government bonds and reduce risks from contagion to credit conditions for UK households and businesses.” Read that last bit slowly and let it sink in. This is not contagion as in preventing the mass sell-off in Gilts from infecting other asset classes and causing a run on the entire financial system in echoes of September and October 2008. Rather, the bank is saying it wants to reduce the likelihood that spiking Gilt yields translate to much higher consumer and business borrowing costs, especially for people on variable-rate mortgages. It is trying to avoid temporarily driving up the cost of borrowing, in the same way mortgage rates’ spiking parallel to Gilt yields two weeks ago contributed to the first intervention. We aren’t passing judgment on this as a goal, but what the bank is trying to stave off is not traditional “contagion” as so many understand it post-2008.

In our view, contributing to a panic through poor word choice is an unforced error. Perhaps the BoE has also realized this, as Tuesday’s announcement opted for more obtuse language, saying “the prospect of self-reinforcing ‘fire-sale’ dynamics pose material risk to UK financial stability.” That still seems overstated to us, but it is at least a more accurate reference to the acute problem of forced selling and, based on Gilt yields’ intraday movement thus far, didn’t fan fears. Regardless, we don’t think the UK bond market’s current travails change much longer term. Market plumbing problems aren’t new. They have always existed, in one form or another, and occasionally they bubble up to the surface in a way that contributes to volatility. We saw it a bit in US Treasury markets as well, when investors’ desire to sell outstripped what the limited number of American dealers could handle, gumming up liquidity temporarily. But these instances are usually temporary. They appear at times of heightened volatility before fading into the background as more normal market movement returns.

Note, we aren’t calling the system perfect, nor are we weighing in on LDI overall. Pension regulators are reportedly planning to look into this situation and may recommend some changes, which might be sensible if they can identify the most beneficial solutions and minimize the risk of unintended side effects. Considering hedging strategies are typically meant to reduce volatility rather than exacerbate it, some of the relevant fund managers could very well elect to make changes on their own and limit their use of these instruments going forward.

But for investors today, we think what matters is that LDI triggering forced Gilt sales probably has more bark than bite as a broad financial market driver. In our view, it is largely a sharp after-effect of this year’s bond market decline, which doesn’t look likely to last—not with inflation expectations coming down throughout the developed world, which should help mitigate upward pressure on long rates globally. While bond market moves tend to be global, the fading furor over the mini-budget should also help improve sentiment toward Gilts, rendering the LDI panic a Flash Crash-like curiosity over time.