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Thursday, September 29, 2022

I have not seen too many longer articles about the “gilt crisis” in the United Kingdom, but have seen a variety of reactions on Twitter. My reaction is that the discussions reminded me why I mainly followed people who used the title “rates forecaster” and not “economist” when I was in finance. (The “rates forecasters” might have had economics degrees, but they knew that if they wanted people like me to take them seriously, they needed to not sound like the people with “economist” in their title.) It is rather impressive how the most interesting part of this crisis has been buried.

We finally have had the financial instability crisis that everyone was a bug about throughout the 2010s. Many people have spent more than a decade calling for a repeat of the Financial Crisis — well, we just had a small version of it. Based on the initial reporting (which may not be perfect), pension funds managed to blow themselves up with leverage (created by fixed income derivatives) by crowding into one side of a trade. This alleged distress forced the Bank of England to intervene to reduce gilt yields (and hence swap rates).

It is not as if this is some kind of “once in a century” event. People have managed to blow themselves up with fixed income derivatives in 1994, 1998, and 2008[1], each of which ended up with central banks getting involved in some fashion. (I am not counting the many derivatives accidents in other markets, most of which were allegedly due to “rogue traders.”) Given that central banks ended up reacting to those blowups, there is no real excuse for economists to not pay attention to those episodes.

It seems entirely possible that this crisis will not have much in the way of economic ramifications, very much unlike 2008. What (allegedly) happened is that pension funds were caught by margin calls as a result of rising long-term interest rates. (This Financial Times article offers an explanation.) The sterling market is notorious for being dominated by a small number of players, much like the Canadian dollar market. In such an environment, once it is clear that some entities are facing margin calls, they will be squeezed unmercifully. That is why gilt yields spiked in an unruly fashion. However, the Bank of England intervention turned the hunters into the hunted — the shorts needed to cover, and were squeezed in turn. This allowed a partial recovery of bond losses, which might allow pension funds to get their liquidity position under control.

For this article, I am assuming that the reader understands what a margin call is, and not explaining what I believe what happened in detail. I will offer an explanation of how pension funds were operating in a later article.

I Blame Society The Pension Funds

When I was in finance, I was a secular bond bull, but I am now recovering. I can understand why fixed income managers at those pension funds might not have believed that rates could rise that quickly. However, it made no sense that they were this exposed to the liquidity risk created by margin calls.

The Fed did its first 75 basis point hike in May, and the crisis hit at the end of September. Even if one was bullish bonds, a 1994 style bond Armageddon scenario had to be taken into account by risk managers. Furthermore, they had to know that swap liability matching was a crowded trade, which meant that any squeeze was going to take rates outside of recent historical volatility experience. Portfolios should have been de-levered and liquidity lines built up.

The Gummint Done It!

Among the economist views I have seen, blame has been laid at the feet of the Truss government and/or things like a balance of payments crisis.

Of course, the mini-Budget triggered a rise in rates. That is what happens in a floating currency sovereign with an inflation targeting central bank: rates are expected to go up if demand increases. I have not read a gilt investment prospectus, but I strongly believe that at no point are there any guarantees about what happens to secondary market yields. Meanwhile, the Bank of England helpfully explains:

Our job to make sure inflation is low and stable, so we need to bring inflation back down. The way we do that is by increasing interest rates.

So yes, interest rates rising is exactly what you should expect to happen, and we do not need to invoke the balance of payments, bond vigilantes or whatever to explain this. The problem is that U.K. pension funds seem to have forgotten that yields can go up, and there are no guarantees about the speed of the rise.

I do not live in the United Kingdom, and I do not have any strong opinions on the wisdom of the Truss/Kwarteng mini-budget. But I certainly would not use a rise in bond yields as a signal that policy is bad. If we used that logic, the economic brain trust in 2008 that threw the global economy into depression and then left it in a state of stagnation for about a decade thereafter were the best economic managers in the post-war era.

As for the balance of payments worriers: the current account deficit did not cause pension funds to neglect liquidity management.

Did the BoE Do The Right Thing?

One may ask: was the Bank of England intervention the right thing to do? Emphatically yes. The liquidation of the pension funds would have caused widespread dislocations in the real economy. Instead, the intervention squeezed the shorts, and at the time of writing, generated an impressive mark-to-market gain for the BoE. Maybe I am too cynical, but I would be very unsurprised if a certain amount of skulduggery was involved in the pension fund squeeze. As a result, I am not going to be shedding tears for the victims of the BoE squeeze.

One of the key jobs of the central bank is to ensure an orderly market in central government securities. If that means throwing shorts under the bus every so often, so be it.

Minsky Moments

This episode is yet another example of the “stability is destabilising” argument of Hyman Minsky. Firstly, we had gradualist central banks taking the volatility out of rate movements. Secondly, we had major efforts to increase regulation to make derivatives “safer.” As Minsky’s arguments would suggest, that just allowed people to grow a really big interest rate swap position that generates a corresponding really big liquidity event.

So we finally ended up with the financial crisis that has been predicted by someone every year since 2008. So far, not as flashy, but it is pretty easy for a central bank to clamp down on interest rate volatility.

I would note that this event was not linked to the real economy, so it did not feature the investment accelerator dynamic that we saw in 2008. (Reckless real estate lending led to construction.) This cycle was confined to the financial sector. Thus, this event was not a full “Minsky Financial Instability Hypothesis” episode.

Contagion?

It is entirely possible that other things will blow up in the global financial system in the coming months. However, direct contagion outside of the U.K. is a hard sell. Liability matching is a domestic issue: you do not enter into liability matches in foreign currencies. So foreign entities will not be caught up in GBP issues. And liability matching was generally more popular in the U.K. than other economies, so similar blow ups are less likely. If only a few entities in a market are doing the same strategy, they are far less susceptible to squeezes.

Interest Rates Might Go Up. That’s What They Do.

A quite likely outcome is that gilt yields will rise after the short covering has subsided. Although many prices linked to international trade are weakening (e.g., shipping costs), there will still be price pressures linked to the fall of sterling and the rise in energy prices. So long as the rise in yields is orderly, the Bank of England can resume its quest of chasing after a lagging economic variable.

Although the rate hikes cannot do much about things like energy, British households are over-exposed to the housing market and mortgage payments. (Unlike conventional mortgages in the United States, British mortgages mainly reset based on relatively short-term rates.) This will act as a drag on demand and sentiment. Even if we grant arguments about the mixed effects of interest rates, relatively rapid rate hikes are self-limiting. The Bank does not need to restore sterling to any particular level, so the alleged “currency vigilantes” have limited inputs to the matter.

Concluding Remarks

Economic and financial commentary on this move was entirely predictable, discussing various ideological fixations — money printing, fiscal dominance, current account crises, etc. — and skipped over the fact that this was yet another liquidity squeeze of a bunch of players who trapped themselves on the wrong side of trade. Given that central banks are in an amazing position to reverse liquidity squeezes, the BoE was able to wade into the market and smack people around. The only real lesson we can draw from this is that if regulators move to contain financial instability of a certain magnitude, market positions will just build up to a larger one eventually.

And once again, I will put up a primer describing the swap market strategies that allegedly led to this mess.

1

The derivatives problems in 2008 were centered in the credit default swap markets, but funding derivatives like asset swaps were dislocated as well.


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(c) Brian Romanchuk 2022

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