Pension funds that manage huge sums on behalf of pensioners across Britain are close to collapse amid the “unprecedented” crash in UK government bond markets after Kwasi Kwarteng’s mini-budget, Bank of England He said.
Explaining its emergency intervention to calm turmoil in financial markets last week, the central bank said pension funds in which it had invested more than £1 trillion were under severe pressure with “a large number” at risk of collapse.
The bank said the surge in interest rates on long-term British government bonds in the days immediately following the chancellor’s mini-budget has led to a “self-reinforcing” vortex in debt markets, putting the stability of the British financial system at risk.
“As a result, these funds were likely to begin the liquidation process the next morning,” the bank said.
The central bank said the collapse was at risk of spilling over into the British financial system, which could then have caused an “excessive and sudden tightening of financing conditions for the real economy”.
Threadneedle Street intervened last week after the pound collapsed to its lowest level against the dollar in history and as interest rates on UK government bonds soared to their highest level since the 2008 financial crisis.
In a letter to the House of Commons Treasury Committee explaining the intervention, the bank’s deputy governor for financial stability, John Cunliffe, noted that the biggest market moves came after the chancellor’s mini-budget.
On the day the bank raised interest rates on Thursday, September 22, it said the currency was “widely stable” and that long-term interest rates – or yields – on government bonds rose by about 20 basis points. Only the next day, when Kwarteng unveiled an unfunded £45 billion tax cut, did the bank’s market intelligence identify the first concerns from pension fund managers.
Sterling collapsed about 4% against the dollar and 2% against the euro, Cunliffe said, while long-term bond yields rose 30 basis points amid “extremely poor” conditions for the number of buyers and sellers willing to trade that day.
Sources in the city warned of the emerging “doom cycle” last week for the pension funds invested in them Responsible investment (LDI). The funds invested in complex derivatives, using long-term government bonds as collateral – assets pledged as collateral to back a financial contract.
Amid 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 manage a sustainable tax and spending policy. This means higher yields – which move inversely to bond prices – in reflection of the rising government borrowing cost.
As a result, pension funds investing in LDI schemes faced rolling “margin calls” as the value of the bonds they pledged collapsed as collateral collapsed. The funds then moved on to sell other long-dated bonds they were holding to cover cash demands, which in turn led to more selling pressure in the bond market in a self-reinforcing downward spiral.
Cunliffe said the bank had intelligence that funds were preparing to sell at least 50 billion pounds of long-term government bonds in a short period of time, more than four times the average market volumes in recent weeks, which is 12 billion pounds. pound.
In the immediate lead up to the bank’s intervention, UK 30-year government bond yields rose by 35 basis points on two separate days. The biggest daily rise before last week, based on data going back to the turn of the century, was 29 basis points.
Measured over a four-day period, the increase was twice as large as the largest since 2000, which occurred during the “rush for cash” at the start of the Covid-19 pandemic when global financial markets plunged into one of the worst crashes since the Wall Street Crash of 1929.