Dr. Christian Adler, Co-founder and Director, Astra Asset Management
The now infamous mini-budget announced by former Chancellor of the Exchequer Kwasi Kwarteng on 23rd September 2022 sent shockwaves in financial markets, as investors balked at the complete lack of funding details to support tax cuts.
The result was a precipitous drop in sterling and a collapse in UK gilt prices, with yields rising well above 4% on 10-year bonds and topping 5.14% intraday on 30-year bonds on 28th September. As we now know, the long-dated sell-off was largely driven by pension funds being forced to meet margin calls because of underlying leverage in LDI strategies.
To say that it was a tumultuous period for UK markets is an understatement.
The ripple effects caused by the mini-budget are still being felt. In its latest announcement, the Bank of England has chosen to take on the markets – and indeed reassert its independence from the UK government – by raising rates by another 75 basis points to 3%, as it seeks to fight inflation. That is the largest increase since 1989.
“What we are seeking to do, we’re always seeking to do this, is to find that balance that gets us back to our 2% inflation target without generating unnecessary and costly problems in the real side of the economy,” Huw Pill, the BoE’s chief economist, told CNBC.
Sitting on a small island, it can feel like this is a homegrown problem unique to the UK.
But the UK is not alone. Despite the market volatility in recent weeks, it is important to look at things in a wider context. There are numerous fiscal, monetary and geopolitical triggers to be mindful of in the current environment.
Mortgage rates rose to above 6% in the US earlier this year, for example. While in the EU, inflation has just hit a record 10.7%, and the region has plenty of its own economic growth problems to contend with.
Avert the invert
In an environment like the current one, economic developments tend to follow a familiar pattern: inflation begins to rise, central banks are too late to react, and inflation spirals out of control – peak CPI figures in Europe reached double digits and were just shy of 10% in the US– forcing central banks to hike rates sharply over a relatively short period of time at the risk of overshooting and pushing the economy into recession.
As inverted yield curves are viewed by markets as a sign of a recession looming, central banks, starting with the Fed, prefer to avoid a rapid increase in short-term rates without taking care of the long end of the curve. Given that inflationary pressures have forced CB’s hands as regards short-term rates, it is important in this challenging environment to keep an eye on quantitative tightening.
To keep the inversion of the yield curve as small as possible, long-term rates need to rise alongside short-term rates. For now, the Fed seems comfortable with a moderately inverted yield curve – US 10-years are trading approx. 50bps tighter than 2-years. The Fed commenced QT in spring this year and its balance sheet has shrunk by some $300bn since.
Expect more Quantitative Tightening
I think Chairman Powell will, and should, continue with QT and let the long end of the curve rise by letting the balance sheet run off and potentially by actively selling bonds back into the open market. The known unknown with all of this is, as is often the case, how much political pressure the Fed comes under; but for now, Chairman Powell seems to have sufficient latitude. With the US dollar still being the world reserve currency, the Fed arguably has a bit more room to maneuver than any other central bank.
In the UK, the Bank of England’s balance sheet is circa £1.1trillion (according to Trading Economics), which has ballooned in response to the pandemic. That now needs to reduce too, meaning 10-year and 30-year gilts have to come off the bank’s balance sheet and interest rates will need to go up.
Indeed, the central bank held its first QE unwind auction on 1st November, where it received good demand among investors for its first £750 million tranche. More auctions are expected during November and December, as Governor Bailey aims to take £6 billion off the balance sheet.
Leverage doom loop
With respect to the LDI issue that arose following the mini-budget, it was surprising to learn how much leverage that UK pension schemes were permitted to build up in their portfolios. What resulted was a doom loop, forcing the UK pensions industry to find ways to plug holes and meet margin calls for their LDI strategies, where long-dated gilts are used to collateralize derivatives in those strategies. It is estimated that LDI strategies accounted for GBP1.6 trillion, or 38%, of pension funds’ total assets last year.
As pensions scrambled to meet margin calls by selling other investments whose prices had dropped less severely than Gilts, the turmoil spread to other asset classes and led to a shockwave ripping through the highly liquid AAA-rated CLO market.
This contagion effect is, of course, not limited to UK investors only. European managers and pension funds holding the same paper as their UK counterparts also watched as prices fell, which is why it was critical for the BoE to step in with a £65 billion intervention to stabilize the Gilts market; albeit on a temporary basis.
If they had not done this, the risks of contagion spreading into the broader financial system was definitely a possibility – people will recall that the financial crisis in 2008 had its origin in a subsector of the US mortgage market similar in size to the UK pensions’ LDI strategies.
Globally, there could still be a multitude of potential pitfalls in credit markets as we head towards 2023 and we may see significant swings in asset prices as well as volatility.
The point is that this goes far beyond the UK’s shores.