Tim Robson

Writing, ranting, drinking and dating. Ancient Rome. Whatever I damn well feel is good to write about.

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Why the UK Gilts Market is like the Schleswig–Holstein question 

November 23, 2022 by Tim Robson in Economics


"Only three people have ever really understood the Schleswig-Holstein business – the Prince Consort, who is dead – a German professor, who has gone mad – and I, who have forgotten all about it." Lord Palmerston, British Prime Minister 1859-65

The machinations of the various Danish duchies, their relationship to the burgeoning German Confederation and wider nineteenth century European power politics was famously obtuse; no one beyond the three mentioned by Palmerston ever understood it.

 The Schleswig-Holstein question has become synonymous with a situation too complex to understand. Which is an oblique lead into my main topic today; what on earth happened to the UK economy at the start of October?

 We all know the story. On September 23rd the short-lived Truss government announced several tax cuts and increases in expenditure but neglected to explain how to pay for them. The markets went crazy, and the interest on British government borrowing (gilts) rose exponentially. The Bank of England stepped in to reassure the markets by announcing they would authorise up to £65B of gilt purchases over the next two weeks to stabilise the cost of British government debt.

Then the story kind of went away as other stuff intervened to entertain the media. There were background noises about Quantitive Tightening, pivots, and something Schleswig–Holstein ish about UK pension funds but, it was complicated and so not part of any mainstream narrative.

So, I decided to do a little research as I’m intrigued by the story behind the narrative. I’m going to use a list format below as the story is somewhat complicated, but I’ll try to simplify.

 1)     Pension funds take money in from members. They invest this money and, as pensions become due, they hope that the income from the investments will be sufficient to pay for those pensions. (1)     

2)     This is the ‘matching assets’ process where projected money out is matched by future revenue streams.

3)     Obviously as we’re dealing with many variables and long periods of time, complicated assumptions are made by pension companies to ensure they have the funds to meet their pension obligations. A range of investment options are used (equities, cash in hand, government and private bonds, property investment and a type of derivative known as (LDIs – Liability Driven Investments).

4)     Sorry Tim. You lost me on that last one. LDIs?

5)     LDI’s are basically a hedge. As pension fund projections of income are heavily dependant on interest rates, the pension funds take out what is effectively an insurance policy against interest rate movements. The collateral for the hedge is often government gilts. If the value of these gilts goes down, more are needed (a margin call). 

6)     When interest rates go down – which could adversely affect a pension company’s revenue stream, the policy kicks in and provides funds to smooth the pension company’s revenue.

7)     When interest rates go up – which should in theory be a good thing as more income will come in – the pension funds however need to pay the insurer (I want to use the word counterparty here, but it tends to confuse rather than illuminate). (2)

8)     So, when in September / October the interest rates on UK government gilts dramatically shot up and the underlying value went down, UK pension funds found that their collateral was worth less and that they were suddenly liable to pay their counter-parties lots of money.

9)     This forced pension companies to make fire sales of liquid assets – for example, UK Government gilts.

10)  But, at the same time two other things were happening:

a.     The Bank of England had finally started to unwind its balance sheet of the government gilts it had on its balance sheet (£450B of QE for COVID expenditure for example).

b.     The UK government’s mini budget promised a lot of spend, less government income because of tax cuts and no plan how this was going to paid for. The assumption is that they would have to borrow more by issuing more gilts to finance the new commitments.

11)  So, we have pension funds and the BoE both dumping UK Government gilts at the same time as the UK Government wanted to issue more.

12)  Too many gilts. Not enough buyers. The UK state simultaneously selling off and issuing more gilts. Supply increased, the value went down, the interest rates went up. A doom loop crisis! (3)

13)  Bank of England steps in and reverses itself in a week and goes from Quantitive Tightening (i.e., selling gilts and tightening the money to supply) to Quantitive Easing to prop up the bond market and protect the pension companies from going bust.

 Are we all clear now? Yes, the proximate cause of the issue was the government being opaque about financing of their fiscal plans. But behind the scenes we had a derivative driven pension market (shades of 2008’s crash perhaps) and a Bank of England both restricting and then growing the money supply and being forced to do so by an unwelcome cash-call in the pensions market.

What is the takeaway?

-       Governments need to publish their spending & borrowing plans at the same time. As they are subject to the markets themselves, they need to convince the markets of their plans.

-       QE and loosening the money supply has long term effects.  Interest rates have been so low for so long, LDI’s offered a (it seemed) low-cost way of hedging this whilst freeing up cash to invest in riskier assets with greater returns.

Extraordinary monetary policy should remain just that – only to be used in a crisis and not as an expedient to meet the spending plans of governments who won’t raise finance in more normal ways (tax, borrowing, spending cuts, efficiencies).

-       Complex financial instruments can obscure risk. Until a risk happens. And then they unravel. Regulators need to be stress testing institutions more regularly and with greater supervision. Although the market movements following the 23rd Sept were large, they were not implausible and so needed to be stress tested

And - I hear you ask - what happened to the Schleswig–Holstein regions of Denmark and Germany in the end? Wars happened. The question of who owned the duchies was finally resolved by the macro forces of war and of peace treaties and, sometimes, plebiscites. The complexities resolved themselves by blunt instruments and rough solutions.

Is this how the gilts, QE & pensions markets will work out with market forces playing the role of war?

  Notes

1)     Historically the UK had Defined Benefit pensions organised through employers. What this meant was that employees put money into a pot during their working life and the company guaranteed that when the employee retired, they would get x% of their final salary. Therefore, the company & the pension fund employed to manage the funds have to always make sure the fund is adequate to meet obligations. This is the type of pension fund affected by the recent chaos in the UK gilt market.

 

As Defined Benefit pension funds are expensive and complicated to maintain, the UK has gradually been moving towards Defined Contribution pension schemes in the last twenty years. Here, employees and employers both contribute towards a pension fund with a pensions company. The pensions payable to the employees when they retire are based on the fund performance in future – i.e., the future benefit is not guaranteed.

2)     “To mitigate the risk, of the bank counterparty defaulting on its payments when the contract matures, the bank would post additional collateral as surety against the contract. Typically collateral is posted by whichever party is ‘out of the money’. It is considered good practice and is becoming standard market practice to minimise risk by posting only cash or high-quality government bonds as collateral”  An Introduction to Liability based investment. Can you see the last sentence? This is what happened in the UK Sept / Oct.

3) Like all equities, government bonds follow the same rules; the yield (interest payable) has an inverse relationship to the value. A doom loop happens when – in order to generate cash – institutions are forced to sell their assets thereby lowering the price of those assets. This lowering price degrades their existing assets making them sell more. Lowering the price again.

November 23, 2022 /Tim Robson
UK Inflation, Truss Economics, UK Pensions LDIs, Schleswig-Holstein
Economics
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UK Economy: What the hell is going on?

October 30, 2022 by Tim Robson in Economics

(I wrote this on 3 Oct - nearly a month ago. Apart from a few edits it’s substantially the same as written.)


The more one studies macro economics - the way our financial institutes and government work - the more one becomes depressed.

On the surface, credentialed bankers and politicians, project a veneer of competence; that they know what is going on and that by pushing certain levers, dialling up or down certain controls, they can smooth our economic landscape.

My revelation - probably long overdue - over the last few years is that actually we have incompetents in charge at best, bad actors at worst.

Like the contemporary study of history, economics seems to take perverse delight in ignoring the received verities of the past and acting like everything is new. That there is only now. Now will be different from thousands of years of human history.

So, we - the general public, the uneducated masses - knew instinctively that printing money was bad. Printing money is a childish response that clearly provides a short term relief at the expense of long term stability. We used to look at the cautionary tales of the Weimar republic, Zimbabwe, Venezuela, Argentina, and be thankful we lived in Western democracies where such idiocy couldn’t happen here.

It happened here…

To focus in on the UK. The closing of the economy - needlessly, foolishly - in March 2020, prompted the Bank of England to print £450B of money. Money that was given to government via monetarisation of the government debt (gilts). “How much do you want?” asked the Bank of England. And they printed it and used these funds to finance the governments COVID policy. Money was flying around the stagnant economy not backed by productivity or activity.

So we’ve got inflation. This isn’t a surprise. I’ve been signalling this eventuality for the last couple of years and I’m not that bright. I’m not credentialed. I don’t tend to talk in bogus imperatives. The future is always unpredictable but, based on this writer’s experience and judgement, the fact that inflation was coming down the track seemed obvious.

I’m not a Johnny come lately. I’ve written publicly that inflation was on its way due to crazy policy ideas of the Government / central bank nexus both here in the UK and elsewhere. I went public with my fears. Privately, I re-mortagaged six months early in January of this year because I knew rates would soon go up. So I’m personally very smug about that and glad that I did. But not everyone studies macro economics like I do. The general public look to our governments and financial institutions to look after their interests.

They didn’t.

Proximately, the Conservative government did two things and forgot two other things.

What it did: One, it underwrote the energy costs for both consumers and businesses by introducing an average price cap. As energy is very expensive (due to many factors, some, all, due to actual government policy on fossil fuel withdrawal and elective sanctions on Russia), this policy is very expensive (£100B a year? More? Slightly less). The second decision the government made was to lower taxes or cancel recent tax rises.

I’m generally in favour of lower taxes. I spend my money better than any government. Corporation tax is paid for by everyone and the higher it is, the less companies wish to remain or relocate to the UK. So the cancellation of the corporate tax rise from 19p to 25p was a welcome, and sane move. Lowering income tax. Yes, sure, why not. Cancellation of the National Insurance Tax rise was also welcome. Give me more money to spend in what I deem essential (home, heating , kids, and yes, that dreadful word, savings).

The government also abolished the 45% tax rate for those on over £150K a year and did away with the EU inspired cap on bankers’ bonuses. These two I have a hard time defending. The less tax, the better, always but this is a moment of national crisis with energy costs going up and the cost of living getting out of control. There is an argument of trickle down and the Laffer curve (where lowering taxes brings in more revenue) but this was the wrong time to test this out. The government would have been better to increase tax thresholds and do away with the pernicious fiscal drag we’ve been suffering for years.

But onto the two things missing. Firstly, if the government is spending more via energy support but also simultaneously lowering the tax burden, where does the money come from? It was bloody unforgivable and amateur hour for the government not to address expenditure and financing in the mini Budget. Shocking in fact. Interest rates and bond prices were rising already - worldwide. The Bank of England had finally got around to unwinding their bloated QE inspired balance sheet by embarking on Quantitate Tightening (ie, selling government bonds back onto the market). And then the government announced a major leap in expenditure and tax cuts. These commitments would require MORE borrowing at exactly the wrong time.

The second thing the government forgot was not to get the finance world on its side. Finance works off certainty and the British government seemed to relish in surprise. Pulling in the opposite direction to the Bank of England was a foolish move. Not to engage the Office of Budget Responsibility was equally stupid. Also, the markets were surprised and reacted accordingly. Sell the UK! Inflation and the general rise in interest rates are a worldwide phenomenon. The Uk Government’s stupidity meant they became the poster child for a wider movement and got blamed for all the sins of the financial world.

And onto the final piece. It seems that the rise in the yields of gilts uncovered some murky creatures at the bottom of the swap; pension companies. To improve income flow our pension companies were borrowing money in order to buy more gilts. So not just investing their funds but using those funds to borrow money to make further investments. Shades of 2008 all over again. The fall in UK government bonds left the pension funds exposed and on the verge (it’s alleged) of defaulting on their obligations.

So what did the BoE do? It pivoted and moved from a position of selling government bonds to buying them again. Using printed money. Up to £65B more of QE. Yes, in a time of high inflation, the BoE used its firepower to blast itself in the foot. They blinked and chose (maybe rightly, maybe not) to prop up the nefarious pension companies and abandoned their fight against inflation.

To summarise. Too much QE. Stupid COVID policies. Dreadful energy policy. Out of control government spend with no plan to curtail it. Too much government borrowing. Dodgy financial practices of the pension companies unsupervised by a BoE asleep at the wheel. Resumption of QE leading to more inflation down the track. And finally - maybe the worse sin of all; weakness, U-turns, uncertainty at the top.

And who suffers from this shambolic mess? The public who put trust in short termist politicians (of all stripes, Labour have NOTHING to shout about - they would have spent more during COVID in particular and anyway, because that’s what they do). The public trusted our financial institutions who have, again, let us down. The culpability of our betters leads to recession. Lost jobs. Blighted lives.

I used to think money was amoral. I don’t anymore. It can be immoral.

October 30, 2022 /Tim Robson
QE and Inflation, Truss Economics
Economics
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Didn't know I could edit this!