This has been an unusual week in markets – especially in the UK, and it’s only Wednesday.
It has been a long time since we have seen such wild moves in the currency and bond markets
of a developed country.
Let alone a warning from the IMF, who say that they are closely monitoring recent economic
developments in the UK.
UK banks have been scrambling to pull mortgage products over the last few days and today
the Bank of England had to step in to prop up the bond market as pension funds faced
urgent demands for cash.
So, lets go over why the Bank of England had to step in, what’s going on with pensions,
and what the developments in the UK mortgage market might mean for homeowners.
OK, the rising bond yields and weak currency that we have seen over the last few days mostly
reflect a lack of faith in UK Chancellor Kwasi Kwarteng’s plan to fund large tax cuts and
untargeted energy subsidies through the issuance of debt, backed by a promise of future growth.
The IMF said that they understand that the package is meant to boost growth but warned
that the stimulus package is likely to increase inflation, which the UK's central bank is
trying to fight.
And that really is the essence of the problem.
The UK Treasury is pursuing a strategy that opposes what the Bank of England is trying
to do and the whole thing just looks disorganized and chaotic – because it is.
While it might be over the top to compare the situation in the UK to Turkey or Italy,
the fact that these comparisons are being made at all should be quite a concern within
the UK government.
So, The Bank of England had to step in with emergency action today to halt a growing crisis
in the government bond markets with a £65bn bond-buying program (65 billion pounds converts
into around 65 billion dollars…) They warned that the turmoil in the UK government bond
market poses a “material risk to UK financial stability.”
The decision to intervene was not made by the Bank's Monetary Policy Committee, who
were informed of the decision after it was made by the Bank's financial experts.
This is a surprising move as it comes as the Monetary Policy Committee had been ready to
enact the exact opposite policy - selling government bonds.
That process, which was due to start next week, has been delayed for now.
So why did they have to step in to buy bonds when they had been planning to sell them?
Well, essentially, they had to step in due to problems being faced by pension plans.
I’ll explain the hedging issues in just a moment, but you had a situation where the
Bank of England planned on selling bonds to withdraw stimulus, the UK Treasury planned
on selling bonds so they could add stimulus and Pension funds were forced to sell bonds
for hedging reasons, meaning that you have a lot of very big sellers and not many buyers
at all, and that is a pretty good definition of a liquidity problem.
The Bank of England was clear that they were only doing this to buy time to prevent a vicious
cycle for pension funds.
The Bank of England said its action would be “strictly time-limited” and came after
market participants said there was a “proper shit show” happening in government bond
markets.
I didn’t make that up...
That is a quote from the FT.
OK, so what is going wrong for pension funds?
OK, So, defined benefit pension schemes are retirement plans that pay retirees a fixed
monthly amount, which is usually determined by a formula based on things like how long
you worked at the firm for, and how much you earned.
This type of pension scheme has mostly disappeared (other than maybe for government workers - in
that they are mostly no longer available to new members due to the high cost to employers
– they have been replaced with defined contribution plans).
But there are around 2 trillion pounds (which is approximately two trillion dollars) in
defined benefit pension scheme assets in the UK today.
With these plans, there are usually no employee contributions required – they were historically
employer funded – and there are no individual accounts, the employer just makes regular
contributions to the plan to fund the participants’ future benefits.
Now because a pension plan like this owes money to retirees in the future, the present
value of those liabilities will change when interest rates change.
When interest rates fall – as they have since 1982, the present value of the pension
liabilities will grow, as the amount of money owed is being discounted at lower and lower
interest rates.
Now if the plan was fully funded, the fund manager wouldn’t care about this, they could
just invest all of the money in bonds, and that would effectively hedge the volatility
of the pension liabilities.
But most of these plans are not fully funded, so they can’t do that.
Instead, they’ll have maybe half of their assets in liability matching bonds and the
rest in growth assets like corporate credit, stocks, property investments, that sort of
thing.
They then hedge the risks of this change in present value with derivatives, using bond
assets as collateral.
The expectation (for the fund) is that the riskier assets will deliver good returns over
time, such that the pension plan will eventually be fully funded.
The derivatives are just there to desensitize the plan to future interest rate swings.
So, do they really need to do this?
Well, if you’re running a company that has large pension obligations and you don’t
want to report huge swings in the plans funding status in your financial accounts or to the
Pensions Regulator, it might make sense to hedge.
Most UK defined benefit pension plans hedge their positions through gilt derivatives managed
by liability-driven investment funds (known as LDI) which are run by some of the biggest
asset management firms out there.
This has worked quite well over time, but it means that defined benefit pension funds
are counterparties to a significant amount leverage in the financial system, and that
can mean liquidity problems like we have seen this week.
When interest rates rise, as has been happening, losses on LDI trades will be offset by declining
scheme liability values and so funding ratios should be unaffected.
So, this shouldn’t be a big deal if you have money in one of these funds.
Pension Schemes will have stress-tested rising interest rate environments and set aside enough
collateral to meet margin calls.
But, the recent extreme volatility – driven by the “mini budget” announcement has
been greater than was expected.
As the collateral that had been set aside was consumed quite quickly, pension schemes
had to then; either sell gilts so that they had cash to meet those collateral calls, or
they were kicked out of their derivatives positions because they couldn’t pay up on
time and then they had to sell gilts to avoid having unhedged exposure to further sharp
moves.
LDI funds will have additionally sold index-linked gilts to shore up the cash in their funds.
So, the Bank of England stepped in to calm the situation down.
They are buying gilts to offset all of the other sellers so that trading can occur in
an orderly manner.
They are providing liquidity to the market.
Now, According to the press, a number of Conservative MPs are saying that Kwasi Kwarteng can’t
survive the market turmoil that has been unleashed by his new economic plan.
One former cabinet minister is quoted as saying “I think he’s dead”.
There are also rumors that Liz Truss is trying to distance herself from Kwarteng’s economic
strategy.
I spoke to a friend who is much more knowledgeable about politics than I am.
He compared this to the situation with Yanis Varoufakis during the Greek Government Debt
Crisis.
While Yanis may have been good friends with the prime minister, when things got ugly he
was replaced.
We will have to see.
As I said I have no expertise on this topic, and I’ll be interested to see what you guys
have to say in the comments section.
So, the other big issue that we need to cover is the chaos in the UK Mortgage market.
Some of the biggest British mortgage lenders, including HSBC, Santander, Virgin Money and
Halifax have either stopped offering new mortgages or withdrew certain mortgage products this
week in response to the soaring cost of funding.
The lenders still offering loans pulled many of their deals off the market until the situation
calms down and they can be repriced.
Moneyfacts reported that 935 mortgage products were pulled from the market yesterday alone,
saying that this was the largest daily drop on record, with the previous high being 462
when the first U.K.
Covid lockdown was announced in 2020.
Given what’s happening in the bond market, it is a bit of a no brainer to say that all
banks will likely be pricing their mortgages higher going forward.
Many of my international viewers are probably not aware that most mortgages in the UK are
one way or another floating rate mortgages.
What is known as a fixed rate mortgage in the UK usually has a fixed rate for just the
first two or five years, after which it moves to the lender’s standard variable rate.
People often aim to refinance at that point to lock in for another two or five years.
The hit to British homeowners shouldn’t be immediate as rates rise, but there are
600,000 fixed rate deals due to expire in the second half of this year and 1.8mn expected
to expire next year.
If mortgage rates go up to 6 per cent, homeowners might see their monthly repayments jump by
over 70 per cent.
Now, not everyone will be affected by higher rates, as more than half of British homeowners
own their homes outright with no mortgage, but most of the people in that situation are
retirees.
Credit Suisse published a report predicting that "house prices could easily fall 10%-
15%" based on their analysis.
They say that the house price "correction" would be gradual, over the next 18 months.
That is unfortunately fairly gloomy news.
That is not how things have to go though.
I discussed a few of the options for how the situation might change and improve in my last
video.
Here is a link if you didn’t see that one.
See you in the next video, bye.