On September 6th this year Liz Truss succeeded Boris Johnson as UK Prime Minister.
Truss immediately announced a “bold plan to grow the economy through tax cuts and reform,” and appointed Kwasi Kwarteng as her new Chancellor of the Exchequer.
What followed was a comedy of unforced errors contextualized by the UK government’s precarious fiscal position, and a financial system that is much weaker than the Bank of England has acknowledged.
The mini-budget and the market response
Kwarteng announced his mini budget on Friday, September 23rd. It consisted mainly of a package of major tax cuts targeting an economic growth rate of 2.5 percent a year.
The financial markets hated it:
Today’s UK ‘mini budget’ has triggered a rout in sterling and gilts …The BoE is now in an EM-like dilemma …The UK government and Bank of England need to think fast so that it does not lead to yet another sterling crisis.
The Bank of England didn’t move fast, and the following Monday the pound crashed to a record low against the dollar, barely above parity.
The gilts market (the market for UK government debt) became increasingly unsettled over the following days and came to a head on Wednesday, September 28th, when the long-term gilts market collapsed.
To quote the Financial Times:
‘At some point this morning I was worried this was the beginning of the end,’ said a senior London-based banker, adding that at one point on Wednesday morning there were no buyers of long-dated UK gilts. ‘It was not quite a Lehman moment. But it got close.’
It also became clear that if they did nothing, most UK pension plans would default on their LDI (liquidity-driven investments) swap positions by the end of the day, the consequences of which would be catastrophic. The Bank announced a £65 billion QE package to buy long-dated gilts and bring long rates down.
The gilts markets recovered sharply after the announcement and by the end of the day, the pound had risen to $1.088 against the dollar.
“If there was no intervention today, gilt yields could have gone up to 7-8 percent from 4.5 percent this morning and in that situation around 90 percent of UK pension funds would have run out of collateral,” said an observer. “They would have been wiped out.”
A political crisis and a U-turn
The crisis might have stabilized, but the political damage was colossal.
In an interview on Sunday morning, October 2nd, Truss was still insisting that the tax cuts were essential to get the economy growing again. She was ‘committed’ to the headline income tax cut. There would be no U-turn. But by the end of the next day, she had scrapped the cut. “The lady is for turning,” wrote Sean O’Grady. “Whatever reputation she had for being a potentially strong Thatcheresque leader has been destroyed.” Others agreed. “It’s a very painful decision but we had no choice,” said a cabinet minister. “There was no way we were going to get the budget through.”
In that same interview, Truss also clarified that the tax cuts were Kwarteng’s decision and hadn’t been discussed with Cabinet. Ouch! The next day, Truss refused to confirm that she had confidence in him.
We can safely predict that the UK will soon have a new Chancellor and possibly a new PM too.
Liability driven investments
So what are LDIs, and why are they significant here? To explain, a pension scheme’s main liability is an illiquid annuity book that falls in value if interest rates rise. The scheme hedges this risk exposure with a liquid interest rate swap (IRS). When there is a move upwards in long-term rates, the scheme will lose on the swap side but gain an equal amount on the liability side. Theoretically, these should offset each other, to produce a net-zero change in the scheme’s present value. However, the hedge is marked to market and there is a margin requirement to cover mark-to-market losses. When interest rates rise, the losses on the swap trigger margin calls, which the scheme must meet by posting additional collateral (cash) on pain of default. If many firms are affected, there can be a scramble for cash that creates a death spiral in which interest rates are pushed to ever-higher levels.
The potential dangers of hedging an illiquid position with a liquid one are well known. Few had appreciated the scale of the issue as it applied to UK pension funds. Moreover, the numbers involved are over a trillion pounds. Some of these IRS positions are leveraged, and regulators have little data on the extent of this leverage and few controls over it.
Curiously, regulators had spotted the pension fund vulnerability years before. As one insider wrote me: “I remember some sort of row about this in 2015, where the working level supervisors got blamed for raising this as a problem.”
Even so, the issue managed to make its way onto the Bank’s November 2018 Financial Stability Report: “However, it is not clear whether pension funds and insurers pay sufficient attention themselves to liquidity risks.” (My emphasis)
The same Financial Stability Report also reported the results of a stress test and concluded that there appeared to be “no major systemic vulnerability.” They certainly got that wrong! I am not surprised, however. Regulatory stress tests are worse than useless because they offer false risk confidence. Also, having a firm fail a stress test causes hassles for the regulators themselves: The firm would complain to their senior management, who would press the stress testers to make the problem disappear.
Assessment
The government made several unforced errors.
The first was Truss and Kwarteng rushing out the mini-budget without ensuring they had the political support within their own party to get it through. The second was not including large cuts in government spending to demonstrate to skeptics that the mini-budget was fiscally responsible. Such cuts are necessary, not only for fiscal prudential reasons, but also because the UK government sector is already too large.
The Bank also made a big mistake. As the market reaction to the mini budget on September 23rd became clear later that same day, the Bank should have raised Bank Rate – say from 2.25 to 4 percent to pre-emptively support the pound. Instead, it took no action on interest rates until the gilts market collapse forced its hand.
The crisis also exposed a yawning hole in its prudential regulation. The Bank realized a problem, wrongly concluded that it did not pose a major systemic risk, and never followed up. These things happen, but they happen a lot to UK financial regulators, and Governor Bailey himself has presided over a good number of regulatory fiascos. In short, the crisis confirms that UK financial regulation is not fit for purpose.