This is the second of a trilogy of posts (how pretentious, sorry) primarily 'inspired' by the current economic situation. It follows on from my question Was the Tory reputation for competency a myth? (30 October) in which I pondered the oddity that Truss and Kwarteng overlooked Mrs Thatcher's tenet "you can't buck the market". When they tried, sterling and interest rates gave cause for concern but it was the the bond market that bucked Kwarteng out of the saddle. A further factor was the crisis that hit finally salary pension schemes necessitating a Bank of England intervention, where they promised up to £65 billion to buy back government bonds and prevent a 'doom loop' of selling but with a short end date to focus the minds of the politicians on regaining sanity. In the end 'only' £19 billion had to be spent on this emergency form of very specific quantitative easing and the crisis dissipated.
So why are bond markets so important and powerful that they can force a change in government policy when a mini-sterling crisis didn't? Bond markets are normally very boring but one can readily understand why a government like ours with high debt and needing to continue borrowing at a high rate would have a problem if the bond markets jacked up interest rates or, in the limit, even declined to lend. Nevertheless I found an article by Jill Treanor in The Times informative. She noted that historian Niall Ferguson claimed that two hundred plus years ago at the time of Waterloo Nathan Rothschild was as important as Wellington to victory as he had backed the bond issue that funded the British war effort. During the 23 year war with France Britain's debt had doubled to the size of the economy - roughly where covid has taken it to - and Rothschild became so influential it was believed he could dictate which ministers were hired or fired.
The bond market was also critical in the US Civil War. The confederate states issued bonds linked to the price of cotton, their mainstay crop. At first the price of cotton rose and the value of the bonds rose with it. But they fell when supplies came in from other countries. The effect on the confederate states was ruinous. They printed more money which fuelled inflation and the confederate dollar, which was a promisory note with no assets behind it, collapsed to a value of six cents in gold, becoming worthless in defeat.
In more recent times American economist Edward Yardeni coined the phrase 'bond vigilantes' to describe investors who sold US government bonds in an attack on the Federal Reserve's policies. By the 1990s Bill Clinton's campaign manager James Carville quipped that, rather than the president or pope he would choose to be reincarnated as the bond market because 'you can intimidate everybody'. This was after the bond market caused Clinton's ambitious spending plans to be reined back which was fortuitous for the administration as it set the scene for sound economics and the legacy of strong growth which is very much part of the positive element of Clinton's reputation.
In normal times governments issue bonds, investors buy them as they are amongst the safest places to put money, and the rest of us don't notice. How can this market suddenly exercise so much power? Knowledgeable readers can skip the next bit (or critique where I've over-simplified it). Say a government has issued loads of bonds at a face value of £1 yielding 2% i.e. paying a 'coupon' (interest rate) of 2% a year for a period of maybe 10 years. Having bought these bonds, investors don't have to keep them, they can be traded so have a price which can vary up or down. If uncertainty arises, for example because higher inflation threatens to reduce the value of the returns (and the £1 when it is eventually repaid) or in the limit because the market thinks the government might default on its payment obligations, the value of the bonds will fall. As a simplistic example if the value fell to 50p that 2% interest rate on the face value of the bonds would become worth 4% to someone buying the bond at the new price. Even if the Bank of England didn't change base rates interest rates in the market would be affected. The interest rate at which the government could issue new bonds would have to increase - why buy bonds paying 2% when you could buy them yielding 4% and get more money back at the end? (You'd be be buying at 50p and expecting to get back £1 at the end of the term). Only governments that didn't need to borrow would be unaffected.
The bond markets are entirely dispassionate in wielding this power. They have long since not been driven by a single person with the influence of Nathan Rothschild and there is no political dogma driving the many individual decisions that underpin a market shift. All that matters is whether decision makers think their money (or the money of the investors like pension funds they are charged with growing) is safe and earning a worthwhile return compared with other options available to them. When the market ditches gilts it is expressing a view about the future probabilities of inflation and default. Foreign sellers are also expressing a view about the future exchange rate of sterling. Kwarteng's pronouncements led to a step change in those views (fears?) of the future. As Treanor noted it was puzzling that Kwarteng, a graduate in classics and history with a PhD in economic history, seemed so ignorant of the need for a chancellor to have the confidence of the market, especially the bond market.
All that seems pretty obvious, if not to Kwarteng and Truss. But returning to the pensions problem, I wondered why that was so acute to need urgent Bank intervention. Oliver Shah noted that the blow up in defined benefit schemes had been caused by their exposure to "liability driven investing". "Eh, what's that?" I thought, feeling a bit dim but, reading on I smelt a rat. Shah noted LDI is a "leveraged product designed to juice up returns without equity risk". He said a small number of voices had flagged that it was an accident waiting to happen, but it still seemed to take institutions by surprise.
I'm very familiar with the way defined benefit (DB) aka "gold-plated" final salary schemes work. They have three-yearly reviews to show that they can meet their future liabilities to pay out to their pensioners. These reviews have often meant misery for the companies behind the pension schemes for around 20 years now as what the individual employees pay in is specified and so the companies have to pay more in to make up any shortfalls between projected assets and projected liabilities for the scheme. They also have to have enough ready cash to meet the monthly cost of pensions in payment going forward. They usually invest in a wide range of assets but with a mix between equities (for growth) and bonds (for certainty) together with smaller proportions of other assets such as property and commodities. This mix gives an automatic degree of hedging against many scenarios. Normally the performance of equities and bonds are inverse correlated: when one group is doing badly the other tends to be doing well. But not always. Commodities, gold being a classic example, are often poor investments in terms of returns but when times are tough and equities and bonds are under-performing, money often floods into gold, boosting its price. It's rare that an ill wind blows all parts of the market no good. This is all well known, of course, and is the basis for spreading risk in a portfolio.
One of the particular risks defined benefit pension schemes have to contend with is inflation. Depending on how their pensions are indexed they can have to pay out a lot more in £ than expected for the money employees and pensioners have already paid in. This is why DB schemes can be extremely expensive and as rare as hen's teeth outside the public sector*. But LDI is a product, something that these pension schemes buy to manage risk (or, per Oliver Shah, "juice up returns"). How come I hadn't heard of it?
I felt better a week later when I read Ed Conway's column. A veteran analyst called Albert Edwards (must be veteran with a name like that!) said:
Before this I had no idea what LDI was. And I've worked in the finacial market for more than 40 years."
He went on to say:
But that misses the point. When you have QE and low interest rates people do stupid things. They build up structures on the back of low volatility. Then, when you get a bit of volatility and rising interest rates, suddenly you're in trouble".
The trouble the DB pension schemes hit was actually remarkably simple. The first thing to be clear about is that Liability Driven Investment is not a strategy, it's a product sold to pension funds by asset managers such as Blackrock, Legal and General and Schroders. It's a kind of insurance to help pension funds balance their assets and liabilities against unexpected moves in the markets and ensure they have enough cash to meet the payments they guarantee to their pensioners. There was £1.6 trillion tied up in LDI by 2021, which sounds a lot but is actually a small part of the assets of these pension schemes. That was part of the puzzle - the overall funding of the schemes was never prejudiced. This was a classic liquidity/cash flow crunch, just what the LDI product was supposedly created to avoid. How come?
The pension funds have to post collateral (readies effectively) against their LDI derivatives in case they turn sour. The amount required rises and falls with the value of the underlying assets which the derivatives track. Interest rates had been steadily inching up in a well signposted way for months, requiring the funds to cough up more collateral but over a time period that allowed them to find the money. But when Kwarteng launched what he denied was a mini budget (so let's call it 'special financial operation') bond rates soared over a few trading sessions. This surge triggered emergency collateral calls on pension funds in a matter of hours. They struggled to find the cash and had to flog whatever assets they could get their hands on to sell quickly. I read about traders frantically liquidating assets, without even having a certain price, as panic set in. Ironically one of the assets they could sell was government bonds, putting further pressure on their price.
The good news is the Bank's intervention worked and the pension funds are no less healthy overall than they were. The bad news is that the markets remain jittery, there's a colossal amount of debt around post-covid, interest rates are increasing at a speed and scale unseen in many years (probably never seen by any traders under 45) and there could be more unexploded bombs lurking beneath the surface of the financial system. No-one is sure where the next one will detonate. Complacency has grown in financial markets as central banks have nearly always come to the rescue over several decades since the US Fed intervened to save a compnay called LTCM (Long -Term Financial Capital Management) in 1998 - another derivatives fiasco I think. This is the problem known as a lack of 'moral hazard' which encourages too much risk taking.
Which is one of many reasons why too much debt is a bad thing and Kwarteng and Truss were foolhardy in the extreme. "Liz Truss accelerated something that was already under way" one expert told Ed Conway. The reckoning was already coming but her ineptitude accelerated it. Like anyone whose credit card has maxed out you can't go out on a spending spree and getting that debt properly under control will take a long time and will constrain options in the meantime.
Which is Rishi Sunak's 'profound economic crisis'. More on that and, in particular, inflation in part III.
* Actually some very clever actuaries managed to prove to the government actuary in the mid 1990s that inflation proofing pensions need not be prohibitively expensive. The public sector corporation I worked for was accordingly privatised with employees having the option of retaining a fully inflation-proofed pension. Within 5 years the employer's contributions had soared from a "holiday" level of 4% through the 7.5% standard rate to 11% and beyond. Within another decade the company had collapsed and the pension scheme had to be bailed out by the PPF. Beware very clever people!
Sources: (besides my own sketchy and unreliable knowledge):
Political leaders can never outwit the bond titans. Jill Treanor, The Times 15 October 2022
Incompetent Truss has thrown the Bank's big sexy turtle a lifeline. Oliver Shah, Sunday Times 16 October 2022. (Andrew Bailey's predecessor, Mark Carney, dubbed him the big sexy turtle if you are wondering. No I don't want to think about it either. Shah says Bailey has a hapless quality that led a seasoned investor to say "if he can find a dog turd, he just stands in it". That's as maybe but he's had a better time lately than the government or pension fund managers.
The debt timebomb that blew up Truss. Ed Conway, Sunday Times 23 October 2022. This was the latest of many impressive columns by Conway, Sky's economics editor. He is proving a master at explaining issues from this one to how to get to net zero in understandable terms. But I still had to look up the next source to confirm that LDIs are like insurance.
Explainer: what is LDI? Liability Driven Investment strategy explained. Reuters, 12 October 2022
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