The UK financial system is at the center of concerns in global financial markets as ‘cliff day’ dawns. The Bank of England (BoE) has announced it will today end its £65 billion bond-buying program launched to counter the market turmoil that erupted after the Truss Tory government’s 23rd September mini-budget.
The Bank of England has launched a temporary bond-buying program as it takes emergency measures to prevent a “material risk” to Britain’s financial stability. [AP Photo/Frank Augstein]
The bond market’s violent reaction was not the result of resistance to more money flowing into the coffers of corporations and the super-rich through £45 billion in tax cuts. Rather, it was because they were to be funded by increased government debt, while they had to be paid for by drastic cuts in government spending on social services.
The first week of intervention went fairly smoothly as the sell-off in long-dated gilts, which pushed yields to unprecedented levels, eased.
But that all changed this week amid further chaos as markets were confronted with the fact that no long-term solution had been found.
Earlier this week, the BoE had to intervene twice in 24 hours as yields started to rise again.
They performed so-called repo operations. Pension funds looking to cover margin calls from lenders who funded the derivatives to protect their assets in liability-driven investments (LDIs) could place bonds with the bank overnight or for a few days to get cash. This should prevent further sell-offs.
The first operation failed and the BoE had to intervene again to expand the assets that could be deposited with it.
In a statement, the BoE said the purpose of its operations is to enable LDI funds to address risks from gilt market volatility. It said the funds had made “significant progress” in the previous week.
“However, earlier this week saw another significant repricing of UK government bonds, particularly index-linked gilts [those with a mechanism aimed at protecting the holder against inflation]. Dysfunction in this market and the prospect of self-reinforcing ‘fire sale’ momentum pose a significant risk to UK financial stability.”
The threat to the stability of the entire financial system is underscored by the fact that LDI mutual funds manage £1.5 trillion in assets in the UK, according to the Investment Association. When the crisis hit, it was estimated that up to 90 percent of these funds could have gone bankrupt had bond prices continued to fall.
But the BoE’s interventions have so far had little effect. Earlier this week, Daniella Russell, head of UK rates strategy at HSBC, told the Financial Times the measures are “sticking plaster” and insufficient because they “do not fully recognize the long-term nature of the challenges”.
The link between the pension fund crisis and the broader financial system was highlighted in a September 30 statement from the Bank of England’s Financial Policy Committee (FPC), but it was only released this week. The statement was little reported but is of great importance.
“The FPC discussed that further corrections in global asset prices, particularly if sharp and accompanied by rising credit risk concerns, could trigger further and faster redemptions of money market funds and open-ended funds that invest in less liquid and riskier assets,” it said .
The potential for open-end funds, which allow investors to withdraw daily, but use those funds to invest in long-term assets that cannot be quickly converted into cash, to spark a major crisis was the theme of the International Monetary Fund chapter of Global Financial published earlier this week Stability report.
The FPC said that, like LDIs, these funds could be forced to sell debt-financed assets because of margin calls — demands for more collateral to back the loans they make.
This could “interact with lower market liquidity conditions and pose a risk of dysfunction in other funding markets, such as those for high yield corporate bonds [so-called junk bonds whose rating is below investment grade] and leveraged loans.”
In other words, what started as a crisis for pension funds could end in the collapse of the entire financial system.
When his interventions failed this week, BoE Governor Andrew Baily began thrashing about like a king of finance, Knut as he faced the market’s waves and bounces.
At an event organized Tuesday by the Institute of International Finance on the sidelines of the IMF meeting in Washington, he said the BoE’s bond-buying intervention would not be extended beyond today’s deadline.
“We announced that we will be coming out at the end of this week. My message to the [pension] Capital is that you have three days left. You have to do this,” he said.
Whether they have it will be tested soon. But whatever the outcome, the UK crisis marks a crucial turning point in the ongoing crisis in the international financial system, as noted by a growing number of financial commentators.
Financial Times editor Megan Green, chief global economist at Kroll, a financial advisory firm, wrote in a column this week that the UK crisis would not be the last.
“As the easy money era draws to a close amid a global central bank tightening cycle, UK pension funds are among the first institutions to surface. I’m sure they won’t be the last.”
She noted that “an even bigger trigger point is Italy, which is particularly dependent on Russian gas, has little fiscal space and is already under pressure in bond markets despite support from the ECB [European Central Bank] Reinvest in bonds.”
Asked what is likely to fail, she wrote that big US banks are better capitalized, but that’s not always the case in Europe, and “no continent’s regulators can be sure what’s lurking in the shadow banking sector.”
Corporate debt was also a concern for the US, as it had reached nearly 80 percent of GDP in the non-financial sector, with a third of that rated BBB, the lowest rating for investment grade.
Sydney Morning Herald economics columnist Stephen Bartholomeusz wrote that the UK crisis could have been seen as a unique event at the outset, asking: “Could it, however, be a symptom of a broader problem and a foretaste of future crises? ”
The remainder of the article gave a positive response as it drew attention to the tightening of the U.S. Treasury market, the foundation of the global financial system, noting that “the liquidity issues in bond markets that dealers are complaining about suggest…markets.” and financial systems that are fragile and vulnerable.”
Bloomberg columnist Allison Schrager wrote that Britain’s pension stupidity is just “the first buried corpse to have uncovered higher interest rates”. US pension funds had less exposure but had acquired an equally worrying vulnerability over time because “they are underfunded and dependent on risky assets that are paying off” and could find they had less money than they thought.
“Pensions may just be the start,” she concluded, “as the US economy has become dependent on low interest rates. And that means the new source of vulnerability can come from parts of the economy that were once considered boring and safe, like mortgages and now annuities.”
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