September 30 2022
Do we ironically owe them an inadvertent thank you? This may appear to be a very strange suggestion in that, given the turmoil that their latest fiscal plans have brought, that we could even start to think that we owe this to Truss and Kwarteng. I am in no way taking any political sides here but bear with me on this one.
In our special edition of Ear to the Ground we reflected on the turmoil which the fiscal announcements on the 23rd had caused. In particular, we focussed on how the announcements had raised concerns over the economic policies being adopted and the credibility of UK finances. These actions caused a spike in bond yields, right across the government bond curve, with yields for two year, all the way out to ten year, being in excess of 4%.
With Truss and Kwarteng resolute in their position, coupled with the possibility of future tax cuts which could further add to inflationary pressures, the market decided not to stop there. On Tuesday and Wednesday the selling pressure intensified in the gilt market, causing yields to rise ever higher, particularly at the long end of the yield curve.
Then, as there appeared to be no end in sight, we saw an announcement from the Bank of England which took the whole market by surprise, stating that “in line with its financial stability objective, the Bank of England stands ready to restore market functioning and reduce risks from contagion to credit conditions for UK households and businesses.” This saw the Bank commit to making targeted purchases in the gilt market, from the 28th of September until the 14th October, purchases therefore strictly time limited. These purchases are then be unwound in a smooth and orderly fashion once risks to market functionality were judged to have subsided and totalled £65bn.
At first it was thought that the Bank of England were stepping in with another round of QE to support the economy and that by doing so they would help support the gilt market. This was not the case, however. The support was made to stop a spiralling trail of events which was forcing pension schemes to sell their gilt holdings. Let us explain. Pension schemes have known and projected liabilities which must be funded. Historically this was through holding cash bonds, corporate or government bonds, of matching duration. Over the years however this holding of bonds has been reduced in favour gaining exposure through derivatives, such as interest rate swaps. These are trades which are agreed through investment banks. As gilt yields rose on the back of the Chancellors announcement this created losses on these positions, with the investment banks calling on the pension schemes to support these losses through the posting of cash collateral. To meet these obligations the schemes were required to sell their most liquid assets, which were gilts, thereby pushing yields higher, therefore exacerbating the issue and causing the spiral to continue. So, what we ended up with in essence was a liquidity event.
In order to try and generate a higher return on investments, pension schemes have increasingly being using derivatives to gain their fixed income exposure. This allowed them to invest capital into other assets as they seek the potential for higher rates of return. This could include asset classes such as infrastructure and/or private equity. The issue with these two examples in particular however is that they are relatively illiquid and most probably couldn’t be sold in an expedient fashion to meet margin calls as required by banks. So, have Truss and Kwarteng inadvertently identified an asset allocation and liquidity issue with major pensions schemes which the market was unaware of and requires new legislation to address? And are there potentially more liquidity events out there as central banks continue to reign in liquidity and tighten monetary policy? Maybe, but it is a little to be offering a thank you just yet.
Perhaps some may like to offer a thank you for the announcement, made just Monday morning, that they have abolished their proposal to remove the 45% rate of income tax. This had become a very controversial step, with many senior Tory party members threatening not to vote in favour. It was certainly not one favoured by the public, with, according to some polls, the Labour party opening up a c. 30 point lead. Whilst the U-turn on this policy will save the government some pennies, it is relatively small compared to the other policies put forward. We suspect that Sterling and UK assets will remain under pressure until the Office for Budget Responsibility has had a chance to respond to the other fiscal announcements, but that report won’t be due till November.
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