It was a close-run thing. That is a less-than-reassuring summary of the Bank of England’s analysis of its emergency intervention in the gilts market last week. Sir Jon Cunliffe, deputy governor for financial stability, spelled out what was at stake: “An excessive and sudden tightening of financing conditions for the real economy.” Translation: the current bout of turmoil in the mortgage market, for instance, would feel like a minor squall.
Some of the numbers in Cunliffe’s 11-page letter to the Treasury select committee are extraordinary. Pension funds, facing demands to put up collateral to support their holdings in LDIs, or liability-driven investments, were looking at dumping £50bn of long-dated government debt in “a short space of time”. This is a market where daily trading volumes are just £12bn.
“Multiple” LDI funds “were likely to fall into negative asset value” at Wednesday morning’s gilt prices. A process of winding up those funds would have started the following morning, creating more selling pressure and a “potentially self-reinforcing spiral” that threatened “widespread instability”.
Meltdown was avoided when the Bank announced its £65bn gilt-buying programme late morning on the Wednesday; yields on 30-year government IOUs fell by more than a full percentage point on the day. But the speed at which they had risen after Kwasi Kwarteng’s mini-budget on the previous Friday was unprecedented. Over four trading days, the rise in yields was more than twice as large as anything seen since 2000.
That statistic alone should oblige Kwarteng (and a few other ministers) to drop their half-baked pleas that global forces were entirely to blame. Yes, as Cunliffe describes, the global backdrop was poor – markets had been volatile for months and the UK yields rose the day before the mini-budget as the Bank backed its gilt-selling quantitative tightening programme. But, come on, £45bn of unfunded tax cuts, unaccompanied by scrutiny from the Office for Budget Responsibility, turned a smouldering fire into a blaze. The charts don’t lie.
Kwarteng, though, would be on stronger ground if he argued that pension funds’ growing obsession with LDI over the past 20 years has been an underappreciated – and underregulated – risk.
The investment technique itself is a legitimate way for a pension fund, trying to match assets and known liabilities, to dampen volatility. The danger lay in overuse and the leveraging of positions, a factor found at the heart of most financial crises. Both created the risk, if yields moved sharply, that funds would need to raise cash in a hurry to maintain their hedged positions.
The Pensions Regulator, the Financial Conduct Authority and the Bank all seem to have viewed the LDI landscape through their own particular lenses without anybody ever compiling a complete picture. There seems to have a lot of monitoring going on, and very little regulating. Last week’s events were extreme, but surely not unimaginable.
The good news – of a sort – is that the Bank’s financial fire engines didn’t have to turn on all their hoses. Of the £35bn that could have deployed so far under the £65bn gilt-buying programme, only £3.8bn has actually been spent. The mere threat to go big was enough.
The bad news is that the process of learning lessons and ensuring “appropriate levels of resilience”, in Cunliffe’s coy phrasing, has barely begun. The Bank’s next financial stability statement is due next week and needs to answer the obvious question: what is the risk of a repeat?
Practical information is always more powerful than corporate messages
Who knows? A round of headlines about the risk of three-hour rolling blackouts this winter may end up persuading businesses and households to reduce their consumption. Alternatively, National Grid’s scheme to pay people with smart meters to reduce usage during peak hours could save the day. Or, of course, the system operator’s “unlikely” scenario of power cuts may never come to pass.
Yet there is an alarming sense of hoping for the best about all this. Other leading European countries have been running public information campaigns on energy-saving measures. How many UK households could honestly say they know how, for instance, to adjust the flow temperature on their combi boiler to optimise output?
Ministerial reluctance to back an energy-saving campaign seems motivated by, first, a belief that price signals are already strong and, second, by fear of coming across as nannying. Get over it: practical information is useful and a government campaign will always be more powerful than corporate messages. The tone just needs to be right. Ministers should think again.