Pension funds managing vast sums on behalf of retired people across Britain came close to collapse amid an “unprecedented” meltdown in UK government bond markets after Kwasi Kwarteng’s mini-budget, the Bank of England has said.
Explaining its emergency intervention to calm turmoil in financial markets last week, the central bank said pension funds with more than £1tn invested in them came under severe strain with a “large number” in danger of going bust.
The Bank said a dramatic rise in interest rates on long-dated UK government bonds in the days immediately after the chancellor’s mini-budget had triggered a “self-reinforcing” spiral in debt markets, putting the stability of Britain’s financial system at risk.
Had the Bank not intervened with a promise to buy up to £65bn of government debt, funds managing money on behalf of pensioners across the country “would have been left with negative net asset value” and cash demands they could not have met.
“As a result, it was likely that these funds would have to begin the process of winding up the following morning,” the Bank said.
The central bank said the meltdown was at risk of rippling through the UK financial system, which could have then caused “excessive and sudden tightening of financing conditions for the real economy”.
Threadneedle Street stepped in last week after a collapse in the pound to the lowest level against the dollar in history and as interest rates on UK government bonds rose to the highest level since the 2008 financial crisis.
In a letter to the Commons Treasury committee explaining the intervention, the Bank’s deputy governor for financial stability, Jon Cunliffe, suggested the largest market movements came after the chancellor’s mini-budget.
On the day the Bank raised interest rates on Thursday 22 September, he said the currency had been “broadly stable” and long-term interest rates – or yields – on government bonds rose by about 20 basis points. Only on the following day, when Kwarteng unveiled £45bn of unfunded tax cuts, did the Bank’s market intelligence identify the first concerns from pension fund managers.
Cunliffe said sterling collapsed by about 4% against the dollar and 2% against the euro, while long-term bond yields rose 30 basis points amid “very poor” conditions for the number of buyers and sellers prepared to trade on that day.
Ministers had attempted to argue that the market turmoil reflected global factors. However, the Bank appeared to undermine this suggestion, publishing a chart highlighting a sharp rise in 30-year borrowing costs after the mini-budget that was not replicated in the US or the EU.
Sources in the City warned of a “doom loop” emerging last week for pensions funds invested in liability driven investment (LDI). The funds had invested in complex derivatives, using long-dated government bonds as collateral – assets pledged as security to back up a financial contract.
Monetary policy
The job of the Bank of England, which since 1997 has had the statutory task of hitting the inflation target set by the government – currently 2%.
Fiscal policy
The Treasury is responsible for fiscal policy, which involves taxation, public spending and the relationship between the two. 'Fiscal easing' is when plans for tax cuts not are not matched by planned spending cuts.
Budget deficit
The gap between what the government spends and its tax revenues
Government debt
The sum of annual budget deficits – and the less frequent surpluses – over time.
Government bonds
In the UK these are known as gilts, and are a way the state borrows to finance its spending. The fact that governments guarantee to pay investors back means they are traditionally seen as low risk. Bonds mature over different timescales, including one year, five years, 10 years and 30 years.
Bond yields and prices
Most bonds are issued at a fixed interest rate and the yield is the return on the capital invested. When the Bank of England cuts interest rates, the fixed return on gilts becomes more attractive and prices rise. However, when interest rates rise gilts become less attractive and prices fall. Therefore when bond prices fall, bond yields rise, and vice versa.
Short- and long-term interest rates
Short-term interest rates are set by the Bank of England’s MPC, which meets eight times a year. Long-term interest rates move up and down with fluctuations in gilt yields, with the most important the yield on 10-year gilts. Long-term interest rates affect the cost of fixed-rate mortgages, overdrafts and credit card borrowing.
Quantitative easing and quantitative tightening
When the Bank of England buys bonds it is called quantitative easing (QE), because the Bank pays for the bonds it is purchasing by creating electronic money, which it hopes will find its way into the financial system and the wider economy. Quantitative tightening (QT) has the opposite effect. It reduces the money supply through sales of assets.
Pension funds and the bond markets
Pension funds tend to be big holders of bonds because they provide a relatively risk-free way of guaranteeing payouts to retirees over many decades. Movements in bond prices tend to be relatively gradual, but pension funds still take out insurance – hedging policies – as protection to limit their exposure. A rapid drop in gilt prices can threaten to make these hedges ineffective.
Margin calls
Buying on margin is where an investor or institution buys an asset through a downpayment and borrows money to cover the rest of the cost. The upside of margin trading is that it allows big bets and higher returns when times are good. But investors have to provide collateral to cover losses when times are bad. In times of stress they are subject to margin calls, where they have to find additional collateral, often very quickly.
Doom loop
This is where a financial crisis starts to feed on itself, because institutions are forced into a fire sale of their assets to meet margin calls. If pension funds are selling gilts into a falling market, the result is lower gilt prices, higher gilt yields, bigger losses and further margin calls.
Fiscal dominance
This is where the Bank of England is prevented from taking the action it thinks is necessary to combat inflation because of the size of the budget deficit being run by the Treasury. Fiscal dominance could take two forms: the Bank might keep interest rates lower than they would otherwise be, in order to reduce the government’s interest payments on its borrowing, or it might involve covering government borrowing by buying more gilts.
Larry Elliott Economics editor
In the market turmoil after the mini-budget, the value of UK government bonds fell sharply as investors began to lose faith in the credibility of the Truss administration to run a sustainable tax and spending policy. This meant a rise in yields – which move inversely to bond prices – in a reflection of the increased cost of government borrowing.
As a result pensions funds invested in LDI schemes faced rolling “margin calls” as the value of the bonds they had pledged as collateral collapsed. The funds then moved to sell other long-dated bonds they held to cover the cash demands, which in turn led to further selling pressure in the bond market in a self-reinforcing downward spiral.
Cunliffe said the Bank picked up intelligence that funds were preparing to sell at least £50bn of long-dated government bonds in a short space of time, more than four times the usual £12bn seen in average market trading volumes in recent weeks.
In the period immediately before the Bank intervened, yields on 30-year UK government bonds rose by 35 basis points on two separate days. The biggest daily rise before last week, on data going back to the turn of the century, was 29 basis points.
Measured over a four-day period, the increase was more than twice as large as the biggest move since 2000, which occurred during a “dash for cash” at the onset of the Covid-19 pandemic when global financial markets plunged into one of the worst meltdowns since the Wall Street crash on 1929.
On Thursday night, a Treasury spokesperson maintained that the turmoil was a worldwide issue, saying: “While the UK has seen disruption, global financial markets have also seen significant volatility in recent weeks.”
They added: “The UK economy is in a competitive position, with unemployment close to its lowest level in almost 50 years and the second lowest net debt to GDP ratio in the G7. Our growth plan will unleash growth and make the UK more competitive.
“The government is committed to strong fiscal discipline and to debt falling as a percentage of GDP over the medium term. Further details will be set out in a medium term fiscal plan shortly, alongside a forecast by the independent OBR.”
