From Ros Altmann:economist and pensions,
    investment and retirement policy expert

  • pensionsandsavings.com

    Bank of England needs to revise its thinking

    Bank of England needs to revise its thinking

    • Bank of England needs to extend emergency gilt buying programme and suspend QT for now. 
    • Pension funds and LDI are not the sole cause of the gilts crisis and should not be blamed. 
    • Monetary policy and fiscal policy errors compounded pressures from actuarial advisors and Pensions Regulator. 
    • To restore confidence, Bank of England is likely to have to extend emergency gilt market support. 
    • Given the role of QE in undermining gilt market stability, Bank of England should announce it is suspending QT for now. 
    • The capitalist system has been interrupted by central bank bond-buying and past risk models are not reliable, leaving pension funds exposed to unknown risk factor. 
    • Investors in their 50s or 60s in Defined Contribution schemes are potentially at far greater risk than Defined Benefit schemes. 

    Pension funds and LDI are being blamed for causing the collapse in Government bond prices, but that is not the whole story at all. There were a number of causes of this sudden crash in gilt prices – supposed to be the most stable and lowest risk of all assets. Leveraged LDI margin calls created a potential doom loop, with falling gilt yields causing calls for more collateral, which then created further pressure to sell more gilts, leading to yet more demands for extra collateral in a negative spiral.  But the Bank of England’s emergency intervention was not just caused by the pension funds.

    These other causes of the sudden rout are far wider and pension funds are not to blame for any of the following factors:

    1. Rising inflation: Gilt prices have been falling sharply throughout 2022 as inflation and interest rate expectations were revised upwards over the past few months
    2. Monetary policy announcements of ending QE and starting QT: Bank of England announcing a few weeks ago that it was going to start QT and sell £80bn of gilts in October
    3. Bank of England tightening policy by less than markets expected while Federal Reserve tightened more caused a collapse in Sterling: The imminent start of QT was preceded by the Monetary Policy committee decision to raise rates by only 0.5% on their delayed Thursday meeting, when markets were expecting 0.75% and the Fed was raising more aggressively. This led to a sell-off in Sterling as markets were losing confidence in the pound and monetary policy.
    4. Fiscal policy errors: The very next day, the Chancellor’s mini-budget announced unexpected unfunded tax cuts, most particularly for the highest-paid, which created a crisis of confidence in the Chancellor’s commitment to fiscal stability, especially after he refused to publish an OBR assessment of his measures. The IMF then also weighed in, saying the UK’s credit rating was less secure, which further undermined confidence in UK assets.

    All of these came together to create the perfect storm, with no investors wanting to buy gilts, overseas funds nervous about sterling and domestic funds seeing further rate rises on the horizon coupled with Bank of England QT gilt sales.

    There is no reason to believe that the factors creating the selling pressures which led to the rout in gilts will have ended by this Friday. I believe, therefore, that it is highly likely the Bank of England will need to extend its ‘emergency’ support for the gilts market.

    None of these factors has yet reversed.

    1. Inflation remains high, although it could recede in coming months, we shall see.
    2. Monetary policy is likely to continue to be tightened with rates being increased again, but there has been no announcement yet, so the confidence in sterling has not yet been restored and markets will probably remain nervous.
    3. The threat of QT still hangs over bond markets too. It would probably help if the Bank of England announces it will delay its QT plans, so that threat of central bank selling will no longer overhangs the market for the moment.
    4. Confidence in fiscal policy has also not yet been restored either. Hopefully, on October 31st, the Chancellor will take the chance to restore fiscal credibility, but that still leaves over two weeks between 14th October and his announcements, so why would people be buying up gilts during that time? Once we get past 31st October, we may have a bit more clarity.

    Institutional investors will be wary of further rate rises causing further price falls in gilts. And I believe pension investors will hardly be rushing to buy gilts now. Indeed, they may be forced to keep selling to meet ongoing collateral demands, or to unwind hedging. Some schemes may now believe they need more in equities or other assets, to help make up for the massive losses they have been suffering on their gilt portfolios so far this year.

    Therefore, there remains significant risk that the gilt market will not be stabilised by the Bank of England’s actions – possibly the reverse after October 14th. There seems to be insufficient recognition of its own responsibility for market conditions.

    Defined Benefit (DB) pension schemes are still facing strains but they are liquidity problems, not necessarily solvency problems unless they are forced into fire sales of long-term assets:  All focus has been on Defined Benefit (DB) pension schemes, who have been encouraged by Regulators and actuarial advisers in the past ten years or more, to focus increasing portions of their asset base on investments that move in line with gilt yields, as this is the benchmark used to value their long-term liabilities.

    This ultra-cautious approach was partly caused by the Bank of England’s gilt-buying activities from QE.  Creating hundreds of billions of pounds of new money and using that money to buy Government bonds, created huge problems for pension schemes, because the lower bond yields fell, the higher the pension liabilities were. That meant pension funds had to have more money today, to meet their pension obligations to members in the decades ahead, because they could not expect to earn very high returns on the money. With such low yields, which were driven ever lower by the Bank of England’s ongoing QE policy, pension funds were encouraged by Regulators to have more of their money invested in gilts and bonds, to reduce the risk of their assets falling well behind rising liabilities.

    But just earning gilt yields would not be enough to overcome DB deficits or to keep up with future liabilities, which actually rise by more than gilts: DB schemes need higher returns than just gilts and bonds, because their liabilities, although discounted by gilt yields, also increased in line with other factors, such as price and earnings inflation, and costs of managing the schemes. Yes, they can get extra money from sponsors, but not all of them can do this. To earn more than gilts or bond yields, funds were encouraged to find better returns from assets such as equities, private equity, hedge funds, infrastructure and property, all of which were expected to be higher risk than gilts but hopefully would generate better returns. To be able to protect their downside risk against liabilities, while also benefiting from better returns to help overcome deficits and keep up with liabilities that increased by more than just gilt yields, the Regulators and central banks encouraged schemes to borrow money and use the funds to generate better returns over the long-term. However, the rout in the gilt market was so extreme in the last couple of weeks, that it exceeded all the risk-related scenario planning that was done.

    Gilts were meant to be stable, low-risk and less volatile than other assets:  The capital asset pricing model is based on the notion that gilts are the lowest risk or ‘no risk’ asset, but that has turned out to be wrong. QE central bank gilt purchases artificially distorted the government bond markets, adding risk which had previously not been a material influence. This undermines the very essence of capitalism, since other assets are priced relative to gilts and historic assessments of risk are based on previous price changes, that were not interfered with by central banks.

    Capitalism is based on asset risks that have proved wrong as QE distorted the lowest risk asset: Risk models did not predict that the higher expected return assets would strongly outperform gilts and that gilts could plunge by 30 – 50%, performing more like hedge funds than stable assets. This danger has not gone away, but for DB schemes, at least in theory, there are many years over which the losses could be recouped. There is a danger, of course, that the employers will have to put far more money into the schemes too, which may not be affordable, but again this would not have normally crystallised in just a few days. The problem was that the derivatives used for Liability Driven Investments (LDI) and the leverage fell so much in price that collateral calls required pension funds to find immediate cash or gilts to pay for these paper losses. If gilt yields continue to fall after 14th October, then this cycle of asset sales could resume.  It is true that many schemes have now reduced their leverage, or unwound their hedges, but they ideally need more time to restructure their portfolios, especially if they are holding illiquid assets that were designed to deliver returns over many years and cannot be easily sold at market prices.

    I also hope that we do not get pension funds offloading good long-term assets at knock down prices in order to increase their liquidity: This goes against the principles of successful long-term investing and hands windfall gains potentially to buyers who come in to take those assets, while the pension funds – and their sponsoring employers – lose out.

    But there is an even more serious problem which seems to also be overlooked:

    Members of Defined Contribution (DC) pension funds in their 50s or 60s, are even more at risk than those in DB schemes: Members of DC schemes, especially if they are in lifestyle or target date funds and close to the age at which those funds expect them to ‘retire’, are particularly at risk. These individuals, who will have a very high proportion of their fund in gilts and bonds, may have lost a significant amount of their pension fund in the recent turmoil and there is no employer standing behind their pension at all. They will just be at risk of being much poorer for the rest of their life, because their fund managers were selling their higher expected return holdings, in order to switch into supposedly lower-risk, more stable assets as they approach retirement. These supposedly low risk investments in gilts or bonds have turned out to be extremely high risk, losing 30% or more of their value in a short space of time. This was not what they were led to believe would happen to their money and is a real danger for those in their 50s and 60s.

    The Bank of England’s QE policy has, to a significant extent, created this turmoil but it is not recognising the big picture: It was probably always inevitable that QE would cause some kind of crash when it ended, but it seems the central bank is oblivious to its own role in this meltdown and is focussing on only a small part of the overall problem. There are many causes of the current situation, with responsibility shared between bank of England’s monetary policy handling, the chancellor’s fiscal announcements, the regulatory encouragement of supposedly low risk liability matching investments which drove funds to need to use leverage to earn higher than gilt returns needed to pay the pensions and then the pension funds themselves using more leverage than they ended up being able to manage during an exceptional gilt crash.

    It is vital that the central bank stands behind the gilt market for longer and puts QT on hold, so that confidence in UK monetary and fiscal policies has a chance to recover. The present situation is dangerous for growth, damaging for pension schemes and could be disastrous for older pension savers who may already have lost a huge chunk of their retirement savings. This emergency has not gone away and must be carefully managed.

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