Ear to the Ground

October 14 2022

Eyes have been firmly focused on the US this week as investors awaited the latest inflation print. Although a lagging indicator, the level of inflation in the economy is the main factor driving the US Federal Reserve monetary policy. The headline inflation for September came out at 8.2%. Feelings were mixed on its release. Although it was lower than the previous month’s reading of 8.3% and was the lowest reading the in the last 7 months, it was marginally ahead of the forecast of 8.1%.

Of more concern to the market was the core CPI figure which excludes the more volatile food and energy costs. Here we saw the rate rise to 6.6%, which was the highest reading since 1982 and above the reading seen in August of 6.3%. This was also above the market forecast of 6.5%. It was this figure which left the market initially thinking that the US central bank have no choice but to remain on its tightening path. Indeed, the latest forecast for the terminal rate is very close to the 5% figure. The 30-year US fixed rate mortgage rate continues to rise as a consequence, hitting a level which has not been since the turn of the decade. This has ramifications in terms of the increase in the cost of living and the potential of the housing market in terms of transactional value and house prices.

Without a shadow of a doubt, however, the main news in the UK has been the standoff we have seen between the UK government and the Bank of England. If anything, this has certainly reinforced the independence status of the latter. It has now been well documented that, as a result of rapidly rising gilt yields following the fiscal announcement made on 23 October, the central bank was forced to step in and purchase gilts to stop yields spiralling higher and higher.

This caused a particular issue for defined benefit pension schemes which use liability-driven investments (LDI) in their scheme. This is heavily derivatives based and as the yields rose sharply, so the underlying banks with whom these derivatives were asked for an increase in collateral to be posted. The agreement struck with the issuing bank will state quite clearly what collateral can be posted in such an event. What became clear was that a sufficient level or quality of assets to meet these collateral calls were not being carried. As a consequence, they were forced to sell those assets within the scheme with high liquidity, i.e. gilts, which sent yields even higher. To maintain an orderly market, the Bank of England was forced to act.

There has been lots of press covering this story, with some claiming that some defined benefit pension schemes came close to collapse. This is something which The Pensions Regulator (TPR) has been quick to squash. The chief executive has spoken and confirmed that newspaper headlines, such as those suggesting pension funds “almost collapsed amid market meltdown” or were “hours from disaster” were simply not true. Other types of pensions, such as defined contribution, were not affected, except of course by the change in market asset prices which were seen.

The Bank of England were very clear from the beginning however that this bond-buying program would only be temporary, with an end date of 14 October. There was pressure exerted this week for them to extend it but they have decided to stay true to their word. In almost a challenge to the government to address the issues which the fiscal announcement has caused, the central bank warned that programs/schemes had until Friday to sort out any liquidity issues they may have. This of cause caused a further spike in gilt yields and on Wednesday the 10-year gilt yield hit a recent high of 4.632%.

The challenge to the government from the Bank of England however appears to have been acknowledged. On Friday we saw the Chancellor replaced and the decision to let corporation tax rise to 25% as initially planned returned to the agenda. This decision is expected to raise £18bn per year and go some way to filling the hole made in UK finances. At the time of writing, markets have responded positively, with equity prices rebounding and the 10-year gilt yield at 4.13%. This of course helps out pensions schemes and the issues they had last week, but we are still above the low we saw on the 23rd of September before the announcement of 3.452%. Time will now tell if markets and investors want the government to go further.