October 13 – 12:50 AM EDT
“The problem with fiat money is that it rewards the minority that can handle money, but fools those who have worked and saved money”.
– Adam Smith
Markets are in a panic. Rates are skyrocketing. Bank of England’s Bailey is giving a three-day deadline to UK Pension funds to rebalance their portfolio (by the 14th or Friday). What is going on? Is this a black swan – was this unexpected?
Not exactly. In fact, it’s essentially been a given – for years.
In the depths of the financial crisis of 08-09, major banks conducted a series of fire sales to unwind considerable positions of mortgage-backed securities and other derivatives. These banks were overleveraged, and high volatility had broken their models.
The bounds did not account for the fact that A: The derivatives were fraudulent in their ratings, meaning “garbage (data) in, garbage out” and B: A significant recession/pullback was inevitable.
When you don’t account for that, and you’re leveraged, you’re in for a bad time.
Here’s what a New York Times Article straight from 2008 said.
“Perhaps the most remarkable aspect of the credit boom that preceded the current bust was the belief of professional investors that they had found a way to increase their profits without taking on risks.
Very sophisticated financial models showed no risk whatsoever in AAA-rated mortgage securities. The underlying mortgages might lose money, the models showed, but built-in safeguards assured that the securities were well protected.
It turned out the models were wrong.
The idea that the route to higher profit runs through higher risk has been around for a long time. The phrase “nothing ventured, nothing gained,” dates to Geoffrey Chaucer in 1374, about six centuries before computers began to run regressions to find ways to get rich without risk.”
The New York Times, August 21, 2008
A lesson that was all too soon forgotten. Or, at least not applied. Thomas Jefferson said it well…
As central banks have the ability to intervene in financial markets, when events producing a systemic risk unfold, these “gamesters” or at least the underlying attitudes, can be impervious, sticking around for a while longer.
And that they did.
In response to the great financial crisis, central banks did the predictable thing. Bailed out most institutions (in need of it) with the introduction of Quantitative Easing (hard to remember a time before it, eh?). When someone is given the choice between a continuation (albeit inherently temporary) of growth, or a major recession or depression, they’ll tend to the former.
You see, the Bank of England and Pension Regulators run “stress tests” to ensure preparedness for economic turmoil. Meaning, seeing what would happen if rates increased significantly in percentage terms from where they were. Let’s just say, they weren’t using the rate at which rates are now increasing (if they were content with the results of the tests, which it seems they were).
Just as projections/stress tests made prior to 2008 for what could happen were unrealistically optimistic, the same holds true for UK pension funds today. And make that the case for several other institutions as well, including US Pension Funds.
How did pension funds end up here in the first place? As monetary policy brought interest rates to record lows, to increase returns, they leveraged perceived low-risk assets to generate high returns. When you leverage, just as potential returns are higher, so are potential losses.
In effect, an asymmetrical consideration was made, favoring the bullish thesis. Because bonds have been in a general bull market for so long, it’s not unreasonable to say a sort of dissonance or appeal to tradition might play into this.
When inflation started rising to and beyond levels not seen for a long time, it is only natural (and necessary) that the price of bonds go lower (while rates rise as they are inversely and directly correlated).
As they are long on the price of the bond, they are in effect short interest rates. Rates rise enough, they lose.
Now, the chickens are coming to roost for the poorly positioned ones. UK pensions hold £1.3 Trillion worth of Gilts (UK Bonds).
Funnily enough, the pension regulators haven’t put a word in, as Ed Conway points out.
“In hindsight there are some ENORMOUS questions about how and why pension schemes were allowed to follow these investment strategies. And actually that wasn’t the BoE’s job, but the Pensions Regulator, which has been curiously absent from the recent debate.”
It’s safe to say there has been confusion and flip-flopping over the last several weeks. Originally, the BoE was set to gradually ease into tightening (QT). Then, on September 28th they announced QE. The markets expected this would last for a decent while. Instead, this week, the Governor of the BoE came out and said the show was over, only to be followed by a Financial Times article refuting this. Finally, the BoE confirmed the statement. This unclarity in policy isn’t something new. Famously, the governor of the BoE during the 08-09 crisis was originally strongly against the bailouts, before changing his opinion shortly after.
At this point, it seems we’re at the “further intervention is probably not necessary” stage according to the BoE.
“Bank of England Governor Andrew Bailey urged investors to finish winding up positions that they can’t maintain, saying the central bank will halt intervention in the market as planned at the end of this week”.
These are often referred to as government-backed “Ponzi Schemes”. A piece by Doomberg called attention to this point.
“We readily concede the real economy is filled with government-backed Ponzi schemes, legal or otherwise. Take the US Social Security system. New money will forever be needed to pay off old promises and absent the US government’s ability to print unbacked fiat, the entire edifice would collapse.”
Now that quantitative easing by the Bank of England, a major buyer of bonds, is set to end in the next couple of days, which the governor concedes means it’s time to get out because:
- The likelihood that bonds will suffer in the future is high.
- Pension funds are terribly positioned
…rates have gone up:
A broadened timeline:
Considering pension funds hold in excess of 1 trillion pounds worth of gilt, one must ask if they can sell enough (not everything…not most of it, just enough). Maybe. These final days of QE and the unwinding of positions might serve as a temporary delay, but in the end, rates will rise, and QE will need to be restarted to bail out pension funds, and a variety of other vulnerable parts of the financial system. Though it may seem paradoxical to have rising rates in such an environment, it appears this outcome is most likely.
Like the fire sales of 2008 by banks such as Lehman and JP Morgan, pension funds are now experiencing something similar. A paper from 2012 discussing the fire sales of 2008:
“The economic incentive for a capital-constrained firm to sell credit-impaired financial assets even, potentially, at fire-sale prices.
The capital costs associated with holding a credit-impaired asset may be more onerous than a firm is willing to bear. Seeking capital relief, capital constrained firms may have to quickly sell credit-impaired assets, accepting liquidity discounts associated with an urgent sale.”
Because at least temporarily, the central bank of England is almost a buyer of all resorts, it’s fair to say the Bank of England is “fire-purchasing” from pension funds. Instead of the seller in a conventional fire sale accepting those previously deemed to be significantly below market rates, the central bank is accepting all offers/bids made.
Today (10/12/2022), the BoE bought £2.4 Billion in nominal guilts, while rejecting zero offers.
Reviewing this data, however, it appears selling is not too excessive compared to some expectations, showing how the short term can be harder to predict.
Going forward, discounting short-term fluctuations, expect rates to continue their trek upwards. At the same time, look forward to mass intervention by central banks. Only now, the resulting monetary inflation won’t stay muted as seen in consumer prices, as it had for over a decade.