It wasn’t the big hedge funds that exploded, it was the £1.5 trillion leveraged pension fund. The BoE intervened to bail them out and prevent further contagion.
To wolf richter for wolf street.
Over the past few days, the pound has plunged, including Monday’s flash crash, briefly hitting record lows against the US dollar. Long-term bond prices are in a death spiral, with 10-year yields soaring 130 basis points in four trading days to 4.63% earlier today, up 275 basis points seven weeks ago (August (up from 1.88% early in the month). ).
The bond market reaction represents a huge and sudden ‘tightening’ in financial conditions before the Bank of England’s QT kicks in. QT is designed to deliver long-term yields, but has already exploded due to disruption.
This is a market reaction to the new government’s reckless plan to cut taxes, which will fund new debt-financed tax cuts for the wealthy and businesses, as well as new debt-financed spending to subsidize energy costs. , thereby necessitating the issuance of a large amount of new government. Debt, even though inflation has already reached 10%.
The Bank of England, charged with maintaining financial stability, has many issues to deal with. Uncontrollable inflation, currency crashes, turmoil in bond markets, financial stability in jeopardy, and a growing contagion. And some of them need responses that others need. So this is a mess and there is no good solution.
The BoE first opted to maintain financial stability as turmoil in bond markets began to blow the financial system. Leveraged pension funds had been hit with collateral calls triggered by a spike in yields and UK lenders had stopped offering mortgages because no one knew. How to price them amid the chaotic volatility of bond yields.
Worried about “contagion” and “economic stability”
So BoE came out today and said Buy long-term gold coins with a remaining maturity of more than 20 years. Purchases are available until October 14th.
“Once risks to market functioning are judged to have subsided, purchases will unwind in a smooth and orderly manner,” it said.
And the 10-year yield plummeted about 60 basis points to 4.01% now, undoing the early spikes of today and yesterday.
Specifically, the BoE said it was “monitoring very closely developments in financial markets given the significant repricing of financial assets in the UK and globally”.
“This repricing has become more significant over the past day, particularly affecting long-term UK government debt,” he said.
“If this market dysfunction persists or worsens, it would pose significant risks to the UK’s financial stability,” he said.
“This will lead to an unreasonable tightening of funding terms and a reduction in the flow of credit to the real economy,” he said.
“In line with our financial stability objectives, the Bank of England stands ready to restore market functioning and mitigate the risk of contagion to UK household and business credit conditions,” it said.
“To achieve this, banks will make temporary purchases of long-term UK government bonds from 28 September,” it said.
“The purpose of these purchases is to restore an orderly market environment. The purchases will be executed on the scale necessary to bring about this outcome.”
“These purchases are strictly time-limited. They are intended to address specific issues in the long-term Treasury market,” he said.
“The auction will run from today until October 14th. Once the risks to market functioning are judged to have subsided, purchases will unwind in a smooth and orderly manner,” he said.
Leveraged Pension Fund Relief.
UK defined benefit pension schemes, which used an investment strategy called Liability-Driven Investments (LDI), were hit by collateral calls as their long-term arrears went into a death spiral.
“The amount of debt held by UK pension funds hedged with LDI strategies tripled to £1.5 trillion in the decade to 2020.” bloomberg.
BlackRock, Legal & General Group Plc and Schroders Plc manage LDI funds on behalf of pension clients. According to Bloomberg, “Pension companies often use derivatives to match their liabilities and assets.
Sharin Bhagwan, head of pension advisory at DWS Group, told Bloomberg, “The LDI collateral buffer uses historical data to build a model based on potential volatility in the gold price. is set
Indeed, this strategy is very conservative, completely risk-free and very suitable for a £1.5 trillion pension fund. until it suddenly explodes.
Bhagwan told Bloomberg that the sharp rise in long-term gold coin yields “blown models and collateral buffers.” LDI funds received margin calls from investment banks and had to post more collateral.
To meet collateral demands and maintain LDI positions, the pension plan has asked managers to sell their holdings in stocks, bonds and open-ended UK real estate funds, Bhagwan told Bloomberg.
And that’s exactly how the contagion spreads: by having to sell unrelated assets to meet margin demands.
Bloomberg reported that the BOE had recently been warned by investment banks and fund managers that collateral requirements could cause gold to crash, according to a person familiar with the BOE’s deliberations.
“The BOE’s intervention was necessary to prevent pension funds from being forced to sell their gold bullion, making the vicious cycle even more dangerous,” Aon investment partner Callum McKenzie told Bloomberg.
“The market’s rapid and significant reaction highlights the significant risks facing pension funds that have reduced or been able to reduce their liability hedging,” Mackenzie said.
“Pension funds using only moderate leverage are struggling to keep up,” Mackenzie told Bloomberg before the Bank of England intervened. You are in breach of leverage agreements with LDI’s counterparties and need to sell. ”
The pension regulator told Bloomberg today:
“We are closely monitoring financial market conditions to assess the impact on the funding of our defined benefit pension plans.”
“We reiterate our request to the DB Scheme trustees and their advisors to continue to review investment resilience and liquidity, risk management and funding arrangements and to develop plans accordingly to protect the interests of scheme members. “
The British use of the word “scheme” to mean “fund” is endlessly amusing to Americans, especially in this context where the British meaning of “scheme” is much closer to the American meaning of “scheme”. Please note in particular.
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