By Alexander Jones, International Banker
It was a month of unprecedented chaos for the UK economy and financial markets. Or, to be more precise, 45 days—the entire duration of Liz Truss’s tenure as the United Kingdom’s prime minister—during which her government rubber-stamped economic policies that flagrantly flew in the face of the monetary policy being implemented by the Bank of England (BoE), not to mention the untold hardship faced by ordinary British citizens. The policies immediately stoked an enormous market panic, eventually requiring the central bank to step in and calm nerves before they were completely shredded.
The most significant factor underpinning the chaos was the announcement to the UK Parliament on September 23 by Chancellor of the Exchequer Kwasi Kwarteng of his “mini-budget”—a set of economic policies designed to turbocharge economic growth back up to 2.5 percent. But according to Kwarteng, the best route to achieving this resurgence in growth was, somewhat bizarrely, to alleviate the tax burden, mostly on the wealthiest in the country, to the tune of £45 billion. The mini-budget also pledged a massive rise in government borrowing to fund the tax cuts, which immediately put UK bond markets on edge.
“Truss’s government has lost an opportunity for a sound rebalancing of economic policy,” was the post-mortem of the mini-budget by Brian Reading, the veteran economist and adviser to former UK Prime Minister Edward Heath, writing for the independent think tank Official Monetary and Financial Institutions Forum (OMFIF) on September 26. “Instead, we have ill-chosen measures producing the least benefit to the maximum numbers at the greatest cost. The ‘growth plan’ will have a devastating impact on income inequality, public sector debt, the National Health Service and education.”
The sheer fact that Kwarteng’s expansionary, dovish pro-growth policies seemed to push in the opposite direction to those of the Bank of England’s contractionary, hawkish measures to contain inflation, moreover, meant that the two pillars of UK economic policy—monetary and fiscal—were decidedly at odds with each other. In fact, they weren’t even remotely on the same page. And at a time when a crippling cost-of-living crisis had engulfed the country, a widespread collapse of confidence in UK policymaking transpired.
To compound matters, Kwarteng had refused to allow independent assessments from the Office for Budget Responsibility (OBR) on the potential impacts of the tax cuts on the economy—something which Truss’s successor and current Prime Minister Rishi Sunak described as necessary to “provide reassurance and confidence to international markets and investors”.
But with this “reassurance and confidence” not forthcoming, the UK bond market plummeted. The crash triggered multiple margin calls on UK defined benefit (DB) pension funds, which invest heavily in gilts (gilt-edged securities) and use liability-driven investment (LDI) strategies—mainly derivative contracts—to help their asset holdings generate enough money to match their liabilities in the form of payouts to pensioners. Such LDI products have surged in popularity in the UK—valued at around £400 billion in 2011, they had grown to a whopping £1.6 trillion by 2021, according to the Investment Association. But LDI pension plans were forced to sell their assets, including gilts, which only exacerbated the bond market’s sell-off and lifted bond yields even higher. Indeed, 10-year gilt yields surged to a 14-year high of 4.5 percent on September 27 from 3.2 percent just one week earlier. The pound’s value also tumbled, hitting a 37-year low of $1.0327 against the US dollar.
Such a dramatic loss of confidence in the government compelled the BoE to intervene in the markets on September 28, mainly to subdue the risks of widespread defaults materialising among pension schemes and other pooled LDI instruments after many began cashing in their long-dated bond holdings to raise funds to meet their margin calls from banks on LDI derivatives. “In line with the Bank’s financial stability objective and in order to avoid dysfunction in core funding markets, the purpose of these operations is to enable liability driven investment (LDI) funds to address risks to their resilience from volatility in the long-dated gilt market,” the central bank stated.
To prevent a complete market rout, the BoE pledged to buy around £65 billion worth of long-dated gilts. It also confirmed on the same day that it would delay the planned sell-down programme of its government-bond holdings worth £838 billion, which was due to commence the following week. “Were dysfunction in this market to continue or worsen, there would be a material risk to UK financial stability,” the BoE noted. “This would lead to an unwarranted tightening of financing conditions and a reduction of the flow of credit to the real economy.”
But with the risk of another flareup should the situation again deteriorate still elevated in the days following the BoE’s intervention, banks remained distinctly exposed to a further potential ballooning in margin calls against the pension funds. Indeed, some lenders confirmed with the central bank that several clients were not meeting sizeable collateral calls. And with banks also liberally using reverse repos (purchase and sale agreements) to lend money to pension funds in exchange for government bonds provided by the funds as collateral, the BoE was also concerned that a widespread failure of pension funds could trigger contagion risk via the repo (repurchase agreement) market, which could ultimately expose the banking sector to massive losses and inflict a substantial disaster on the UK’s real economy.
Through company disclosures, the Financial Times revealed that Lloyds Bank was the UK lender most exposed to the repo market at £52 billion, or 8.5 percent of the assets on its corporate balance sheet. Lloyds accounted for around 13 percent of the entire £400-billion gilts-repo market, according to estimates from the BoE, while NatWest (National Westminster Bank) represented the next biggest repo exposure at £25.8 billion, or 6 percent of its balance-sheet assets. Santander’s UK unit, meanwhile, was exposed to the tune of £12.6 billion (4.4 percent); HSBC UK Bank had £8 billion (2.3 percent); and Barclays held £3.2 billion (0.4 percent). “Lloyds definitely have one of the larger repo books, so they would have been one of the larger affected counterparties,” a trader at a rival bank told the Financial Times.
Market confidence was somewhat restored on October 3, however, when Kwarteng reversed his decision to cut the highest rate of income tax. “We get it and we have listened,” both Prime Minister Truss and Kwarteng asserted on Twitter. “Our focus now is on building a high growth economy that funds world-class public services, boosts wages, and creates opportunities across the country.” And the BoE also introduced a new, permanent Short Term Repo (STR) facility during the same week, which offers an unlimited quantity of reserves at the Bank Rate every Thursday, thus boosting liquidity by enabling banks to conveniently borrow cash in exchange for the bonds they own.
Although the BoE was prepared to purchase up to £5 billion of gilts per day to rejuvenate the bond market, LDI asset managers continued to hold off on selling their sterling government bonds, preferring to sell off their other assets first and retain gilts to match their long-term liability needs. With the number of margin calls from banks to clients managing the LDI funds going through the roof as funds frantically sold assets to deliver as collateral, moreover, there was also considerable operational pressure on custodian banks, which were struggling to process the surge in transactions on time.
By October 10, the BoE had expanded its long-dated gilt-purchasing programme from £5 billion to £10 billion per day for the remaining five days. The central bank also launched the Temporary Expanded Collateral Repo Facility (TECRF) to enable banks to ease liquidity pressures facing their clients’ LDI funds through liquidity-insurance operations and confirmed that it would accept additional forms of collateral for lending, including index-linked gilts and corporate bonds. And through its regular Indexed Long-Term Repo (ILTR) operations each Tuesday, the BoE indicated that it stood ready to support the further easing of liquidity pressures facing LDI funds. This permanent facility provides additional liquidity to banks against eligible collateral, including index-linked gilts, and thus further supports lending to LDI counterparties.
In terms of calming the markets, the BoE’s intervention largely achieved its objectives. But since the formal ending of the BoE’s intervention, Governor Andrew Bailey has made clear just how close to a “financial meltdown” the UK had come as a result of the events of the previous weeks. “We certainly reached a point where markets were very unstable, and these were core markets, this is the Government bond market, which is in many ways the most core of all,” he told Channel 4 News. “And it was becoming unstable, and it was affecting…pension funds, for instance, and how they were operating. And our worry was that when you get into that situation, this can easily spread very rapidly and then you have a huge job on your hands to get it back under control. So, we had to step in quickly, and we had to step in quite decisively.” Asked how close the UK came to a total meltdown, Bailey added, “I think at that point when we intervened, I can tell you that the messages we were getting from the markets were that it was hours.”
But while much of the blame may lie at Truss’s Downing Street doorstep, some have expressed sympathy with the now-former prime minister. “The way the Truss government collapsed should concern all who support democracy,” Narayana Kocherlakota, a former president of the Federal Reserve Bank of Minneapolis, wrote in a column for Bloomberg. “The prime minister was seeking to fulfill her campaign promises. She was thwarted not by markets, but by a hole in financial regulation—a hole that the Bank of England proved strangely unwilling to plug.”
Daniel Lacalle, professor of global economy at IE Business School in Madrid, also pointed out, in defence of the Truss administration, that those who were vehemently in support of massive deficit spending and money printing as the solution to the global economy were now blaming the turmoil of the UK bond and currency markets on a deficit-increasing budget. “The total assets in LDI strategies almost quadrupled to £1.6 trillion ($1.8 trillion) in the ten years through 2021. Nearly two-thirds of Britain’s defined benefit pension schemes use LDI funds, according to TPR and Reuters,” Lacalle noted in an article for the Austrian economics think tank Mises Institute. “Liz Truss and Kwasi Kwarteng are not to blame for this insanity. The policy of negative real rates and massive liquidity injection of the Bank of England is. Kwarteng and Truss are only to blame for believing that the party of policies of spending and printing defended by almost all mainstream Keynesian economists should work even when the music stopped.”
Bailey has since pushed back against Kocherlakota’s assertions, however. “That, I’m afraid, is wrong. If we had gone on longer than that, we would have created a moral hazard problem” where investors think the central bank will always step in to protect them, Bailey said in an interview with Bloomberg Television. Speaking separately to Channel 4 News, moreover, Bailey further defended the central bank’s response: “Our intervention, as a central bank as it should be, was to address a precise financial stability problem. Our conclusion was that by the point that we said we would end that intervention, we had restored stability to that part of the world, and I think all the evidence since then supports it.”
And yet, Truss and Kwarteng might receive a modicum of validation in the end for their persistence with a pro-growth agenda—albeit one that perhaps shouldn’t have focused so narrowly on benefiting the wealthy—after the BoE’s Monetary Policy Committee (MPC) raised interest rates by 75 basis points on November 3, the biggest hike since 1989, and warned that the UK now faces the longest recession since records began around 100 years ago. But ultimately, the UK economy remains caught between a rock and a hard place: Drive growth and risk inflation running rampant, or raise rates to contain prices and endure a painful recession? There are simply no easy answers at present.