Bonus episode: What the gilt meltdown means

you know, they're that exciting. So we'll go to try and really break it down to make everyone understand what we're dealing with and what the wayfold is for the Bank of England. In the studio, we're joined by Christina Kino, Managing Editor of Markets and Lucia gift Apolo Asset Management Report. Although we're calling her a pension queen, right because it's all about pensions this week, right, I mean all the

danger they were in, I mean that's how bad things got. Yes, I think they have become quite sexy the last few days. Defined benefit pension funds, which are the funds that guarantee savers a set payment when they retire, so regardless of the swings of the market, they a couple of weeks ago they just found themselves into a death spiral where

they were causing their own demise. They were facing margin calls and as a result they had to sell these long dated bonds which took the price much lower, and then they had to pay more in collateral, so they kind of got into a situation with the Bank of England had to come in and save them, so a death it was literally a death sparal. So these things could have actually gone out of business. So people's people's

actual pension savings are on the line here. Well in a way, yes, so they they use some type of derivatives to do that and these the funds that they use would have had to be liquidated. Now whether the pension funds would become solvent is a different question, and it's not certain they would have, but they would have major life. Has this ever happened in the UK before in the pension industry, No, it hasn't to my knowledge.

In the last so the strategy exists for twenty years and it's the first time they've been that people found out there is this thing actually exists. But but this, I mean, the point is that we had forty eight hours of complete chaos in guilds. But this is should be low risk investing. And once again, and this is usually how crises started. Once again, it's slow risk investing. You know, these strategies that are anything but low risk.

So what did we get wrong? I think that these were meant They worked very well in a kind of low rate environment where they were not wild market moves. But once they started, they couldn't control it because they hadn't faced it before. Some people, some consultants, have said that the volatiles broke through this model that had worked fine for the past twenty years, and now they don't know if going forward they can actually use this in

the way it is right now. I just starting it back bit here, maybe bringing in Christine just Um where this all began with. We've got a new government in Britain, new Chance to the Exchequer, that what they're calling their pro growth Agenda. They announced a huge slew of tax cuts. It freaked out the markets, but the place it freaked them out most was in the government bond market or

the guilt market. Wasn't it. Can you explain a little bit to us more broadly why that happened and how do we get to this point where actually everyone's pensions on the threat. Well, if I think what we saw on bond markets is essentially investors going up in arms

over the UK's fiscal plan. They're calling it a pro growth plan, but what they're really doing is spending more, cutting taxes and doing it in such a way where it's going to be unfunded, i e. They're going to have to increase the amount that they're going to be borrowing from public markets over the next few years. Now. They justified this and they sort of interrupted. They said, look, the market can take more borrowing. They said, Britain's got one of the lowest debts of g D p R

shows of the G seven. You know what we can we can afford to borrow it more. But they got that wrong, right, Yeah, because I think the other side of this, so that's one side of it, right, is the fiscal approach, and this is what the UK plans to do. And yes, maybe in a vacuum, you would think that the government, or or rather the bob market in the UK has the capacity to absorb more debt. But the other side of this is very important, it's

the monetary policy side of it. We are in an environment of a rising rates and rapidly so in the Bank of England already behind as it is versus other peers, was going to have to scramble to raise rates a lot more to get ahold of inflation. And suddenly you have monetary policy and fiscal policy clashing majorly, which really what the bond markets was up in arms about. So look it was this really a miscalculation from the government.

As far as anyone can remember or recall, the UK run a deficit on its current account, which means that the nation, as Mark Arney said, relies on the kindness of strangers. Those strangers or investors. I mean for the long dated bonds, the main investors are the pension funds, and this was one of the problems that there were no natural buyers, so no one was going to buy when they were selling because they the long dated bonds, which are the bonds that would mature in like twenty

thirty years, they mainly owned by these pension funds. I don't know if anyone had thought that this was a possibility in life that this this thing could actually happen and it would just be another obscure part of the market that would blow it all up. But was there also a liquidity problem which regulators are now looking into. There were liquidity problems because the pension funds had to come up with collaterals so fast that they actually not

have time to sell any assets. So they would have to come up with collateral in three or four hours when they usually have ten days to do so, and they were just they had assets to sell. They were liquid in the sense that they had equity to sell, they had bonds to sell, they just did not have any time to sell them. So we had emergency action from the Bank of England to try to try to stop the panic. We've had them again this morning, we're

recording this on Tuesday morning. We've had them again coming out and stepping into the market to try and stabilize things because yesterday on Monday, we saw this huge, i think record increase um in the yields on inflation linked gilts. Christine, can you explain a little bit about what happened yesterday in the historic move Well, I think what we saw

yesterday it was precisely the dynamic that Lucia was describing. Right, you suddenly had this massive sell off in this part of the market that is usually very sleepy, Dave, this doesn't happen on a normal day, but we finally saw it happened because all of these pension funds that had to dump their assets, right, they are mainly the biggest buyers of these inflation linked bonds and suddenly they're having to sell these and that create did the spiral of

a sell off in this market. Investors or maybe third party observers are suddenly seeing, oh my god, there's a sell off. We better get in on this before we get burnt, and that kind of just causes the spiral, the death spiral that the Lukia had mentioned. And again this is why probably we're seeing the Bank of England having to step in, what for the second time in two days. You know you've covered markets for many years here, right, have you ever seen, especially in the boring guilt market,

these sorts of moves ever before? No, not in my lifetime, and I've been in this market for more than a decade, aging myself a little bit here. Uh No, this is really unprecedented at least in the modern ages. And I think this is precisely why investors in the Bank of England alike are probably really really worried. Right now, can

you explain to understand what was really at work? Maybe we need to also understand these liability driven investments, right That's useful because it means basically that pensions funds have to have enough roll re liability to cover it. Dear lord. Yes, so this is l d I is something that has now become the words people talk about. The three weeks ago, I know when when it actually happened, I had investment managers calling me and saying, what the hell is that?

They were googling explainer as to try and understand, and then they were trying to kind of explain it, but we have to explained around the podcast. Yes, So basically this is a type of derivative trade that pension funds used to match their liabilities and their assets so they

have more money to invest in growth assets. So once they are they have enough guilts to pay out their liabilities in twenty thirty years time, when the when when people in the scheme will will be retired, they can use assets to actually you know, grow grow the money that they have. When one prices fall, they have to pay collateral, and when they rise, they get collateral. On this occasion, they fell, and they fell steeply, and they fell fast, so they had to pay a lot of

money very fast. As a result, they now need to have multiple amounts of cash of what they had before to be able to withstand very very wild variations in the market. So they're now selling everything they have to come up with the cash. So you could argue that at some point this was going to combust anyway, and the mini budget was the fire that lit it. I think yes, I think if people have thought the various different scenarios of it, they could have decided that this

is the case. But no one was thinking about that during the very long bull market and low interest rate. So it's it's been a wake up call, I think for everyone involved. So thinking about the real world, if you like impact, there's some people listening to this what we're talking about here might find all they're still pretty obscure, you know, moving around these derivatives and the guilt and the yield and the price action. What does it mean

for people's pensions, for people's savings, for people's mortgages. Well, I think that these are kind of three different things. But one thing is that these chaos is now spelling into other asset classes. So we've seen a sell off in corporate bonds, we reported a sell off in multi asset funds, and I'm sure there is a lot more

happening that we haven't yet reported. So this will affect the prices of other assets that are in people's pensions as well, including not defined benefit but benefit but other schemes. Then for for defined benefit schemes, I think every everyone I speak to they try to downplay a bit. They say, we're you know, there are no solventcy issues here, we're very well liquidated, but we do have to re balance hugely.

I don't know if any of the big schemes will implode, and I would be very worried to say, to make an assertion like that, but you know, when yields go up, the mortgages go up, so people will have to pay a lot more. I think it was a shock. I'm not sure how long it will take to manage, because we've see now the Bank of England doesn't think it's time for it to leave yet, So yes, I mean, savers and and and people who have to pay mortgages are a bit worried. But there's so much money in

pensions on there. You know. It's the ripple effects sore as you're talking about these these these kind of fire sales of other assets that's going to ripple through the economy in ways that maybe we can't really protect at the moment. Yes, I don't think we can't because it's only just started, and investment managers generally say we will

see this unfolding over the next several weeks. So I think it's too early to say with certainty this is going to happen that The signs so far are this is filling into other parts of the market, Christine, when you look at guilts, this is my cf A level twenty five. They're so crazy, right, some of the movements are so crazy. And the Bank of England has stepped in three times to change the parameters to try and

stabilize them. It hasn't worked. What do they need to do for them to you know, stabilize well, for I think we could possibly be looking at whatever it takes sort of moment here for the Bank of England, because so far they've really been on kind of defensive mode. You know. They they look at the market reaction, they decide to do something in response. The market doesn't really um respond all that well, or at least the way that the Bank of England intended, and then that necessitates

even more action from the bank. I think what markets are really looking for is really decisive action. They may be looking for something more broad in longer term, but do they need to persist with the backstop for you know, much longer than actually the end of this week, possibly into that November the third Bank of England decision where

we could see a steep interest rate hike. That's certainly one of the initial steps that we're hearing from investors that could potentially calm the market, extending the length of this backstop um from the current endate, which is meant to be this week. But then also I think this goes back to the very heart of the trajectory of Bank of England policy itself, and we were talking about

a bank that is meant to be tightening policy. They're meant to be raising rates, they're meant to be embarking on the quantitative tightening process, or you know that process of uh, the rolling off bonds from its balance sheet after such a long time of buying them, that might all be thrown into question because of the extent and the speed of what we've seen in terms of the market meltdown and the very real implications that it has

for dependence industry. Yeah, that's been it's been the quantitative confusion. It's been called. Right, they're supposed to be ending quantity of easing with quantity of tightening and then suddenly they're

going back to easy again. And there really is a credibility problem here, isn't It's interesting as you say, we need whatever it takes moment right, that's Marrow Draggy And of course, the last time if you look at your WB function on your Bloodbog terminal, last time you see those sort of bond moves for government bonds across Europe, w for world bonds, for well bonds, thank you very

much on your nearest Blindbog terminal. That was back in the in the debt crisis in Europe, right when Maryo Dragging had to step up and say I will do whatever it takes to save the euro Can you see Andrew Bailey coming out to the steps to the Bank of England and making some sort of dectoration. Well, that's certainly the hope. We don't know if that will actually happen.

I would love to see it happen, because we're right outside the bank didn't spend a single euro sent back then, right where they've already spent, and the market is testing, testing and testing. Yeah. Well, this is the legacy of quantitative easing, and you know this whatever it takes moments and that Mario Draggy kind of laid out as an example of the rest of the policymakers in the world, right, I mean he managed to do it back then. Um, this is more than a decade ago now, but the

stakes have been raised since then. Uh, probably because we have been so used to such a long time of really low rates, really easy monetary policy, very supportive central banks. Uh.

But that is all getting behind us now. You know, we're entering a new era where center banks are really prioritizing inflation potentially over growth, and they may not necessarily uh be you know, it may not necessarily be a contentious thing to see our recession as a result of these efforts to control I mean, you know, with a we've got a chancellor who said, you know, in the initial term or after as many budgets said, the markets will do what the markets do. I wonder how long

that can hold if things continue to spiral. And as you if you say, if there's even a possibility of a big pension fund in danger, I mean, surely it's not just the Bank of Imman need to do something here, right, It's the Treasury and the government as well, isn't It isn't a question they need to get their act in order. But I know that day and speak from the same hymnsheet. Um so I think it's a problem that needs to

be dealt with. We kind of know that there's a lot of lobbying going on to find a way forward, at least on the pen inside. We don't really know yet where this is going to lead, but there will. The things need to change because no one guarantees we're not going to go through the same forty eight hours of chaos, which might be a week of chaos. They say they're better prepared, but cash can only last you

that long. If it's not two days and it's five days, then a lot of the selling has left funds with many liquid assets like private equity, private credit, infrastructure. These are very hard to sell assets, so I'm not sure what is going to happen if they are completely dried

of cash. Thank you both for joining us, Thanks for listening to this week's bonus episode of in the City, and we will be back later in the week, but in the meantime, if you like our show, please head on over to Apple Podcasts or wherever you listen to podcasts, rate review, and subscribe, and also definitely sign up for our newsletter, The Readouts with Legra Stratton on blud dot com, Slash Newsletters, or check out the show notes for a link. This episode was hosted by me Francin Laqua and Me

David Merritt. It was produced by Summer Sadi and special thanks to Christine Aquino and Lucia gift Alo.