Last week, UK Chancellor Quasi Qateng unveiled a mini budget that included a tax cut that overwhelmingly favored the rich and an energy subsidy worth £60bn over the next six months. However, the government’s need to spend without earning income resulted in a sharp drop in the pound and foreign investors dumping guilts, which are British government bonds. This caused the worst day in the UK guilt market since 1990, with a rise in the yield on guilds. Pension funds, which had leveraged ldi funds exposed to moves in guilt yields, were forced to sell assets to post collateral on derivatives trades, resulting in a spiral of guilt fire sales and collateral calls that could have led to a full-blown financial crisis.
Last Week’s Dramatic Market Meltdown: What Happened and What It Could Mean
Last week saw one of the most dramatic meltdowns in the financial markets for years. The potential collapse of the UK sovereign debt market was so severe that it forced the Bank of England to turn on the money printer to calm the situation. However, every action has unintended consequences, and they reared their ugly heads.
Three months ago, Boris Johnson resigned as Prime Minister of the UK. The Conservative Party held an internal election process to determine the new leader of the party and, hence, Prime Minister. Liz Truss won the election, and she named a loyalist and close friend, Quasi Quateng, as Chancellor of the Exchequer. Quateng unveiled a new mini-budget in the House of Commons that did not go down well.
Contentious Parts of the Mini Budget
One of the most contentious parts of the mini budget was a tax cut that was overwhelmingly favorable to the rich. This meant that the government would be short of £45 billion. The energy subsidy was also a problem, as it would cost £60 billion over the next six months. The fiscal package’s overall cost over the next five years could be as much as £161 billion, which led to the inevitable question of how it would be paid for.
The Resulting Market Shock
It is difficult to spend without earning income, so the UK borrowed money. However, the market was not happy to invest in the sovereign debt of a country becoming less creditworthy and not too happy to hold the currency of a country that is likely going to feed inflation. The result was an unprecedented shock to the financial markets. The pound hit a near all-time low of 1.4 cents, and the guilt market was in free fall.
Problem with Guilts
Guilts are the British government’s bonds, and their value began to plummet as foreign investors sold them off. Pension funds, which have the most exposure to longer-dated gilt yields, were in an unfortunate situation. Their liabilities present value of pension payments are discounted using applicable interest rates. New investment strategies involved complicated interest rate derivative structures in what are called LDI (liability-driven investment) funds, including leverage up to four times. This meant that those pension funds or anyone who invested in LDI funds were exposed to outsized moves in interest rates. When their derivative hedges unwound quicker than they could raise the needed cash, Pension funds were forced to sell their assets to free up liquidity to post this collateral.
Risk Lurking Beneath the Surface
This meant that these Pension funds needed to sell other assets to free up cash, and it turned out that Pension funds hold a lot of guilts, which were among the most liquid assets they held. Hence, Pension funds started dumping their guilds too, which caused further falls in the prices and rises in the interest rates on them. Higher rates mean more collateral calls on leveraged LDI trades and more guilt selling until it becomes a spiral of guilt fire sales and collateral calls. It was a self-inducing chain reaction that could have brought the financial markets to a standstill. Unlike in 2008, when it involved banks, this would have involved the £1.5 trillion pension sector.
The last week’s market meltdown was a result of the fallout from the mini budget. Pension funds were caught off-guard and forced into a fire sale of their assets. The market’s risk lurks beneath the surface, and the situation could have turned into a full-blown financial crisis. It could mean a lot more for the markets going forward.