The UK has exposed the catalyst that may cause HUGE problems in the financial world, and that’s the relationship between interest rates and pensions.
Pension funds get money today from workers and pay back that money to workers when they retire, some decades in the future.
There’s no way that a short-term spike in interest rates should create a crisis across $1.6 trillion in UK pension assets! So, what if interest rates spike up and their bond portfolio takes a temporary hit? A pension fund should be able to ride out the short-term ups and downs of markets (“volatility”) and capture the long-term benefit of owning a portfolio of stocks and bonds, right? A pension fund should never be forced to sell their bonds into the teeth of a short-term volatility storm, right? Right?
This collection of promises to repay pensioners in the future (called a pension “liability”) works by exactly the same math as any other promise to repay money in the future: when interest rates go up that pension liability goes down, and when interest rates go down that pension liability goes up.
Seeing your liabilities go up quarter after quarter, year after year as interest rates go down quarter after quarter, year after year is a real drag (literally and figuratively) for pension fund managers. Luckily, Wall Street – in the form of UK pension consultants – was ready with a solution!
In this case it’s the invention of a new way to apply leverage to the problem of liabilities going up when interest rates go down, and it goes by the name of “Liability-Driven Investment” or LDI.
Quite literally, LDI is a hedge fund strategy. It is a strategy to hedge your liabilities by investing in a way that should make money and offset whatever is making your liabilities go up, which is interest rates going down. Specifically in the case of UK pension funds, it is an investment program that uses leverage – borrowed money – to bet on interest rates continuing to go down.
It is called an “interest rate swap, where every day there is a winner and a loser. It doesn’t cost you much cash money to set up, maybe 10% of the total amount that you’re betting on (your 10% earnest money is called “initial margin” and the total amount that you’re betting on is called the ”notional” of the swap), and you can use the other 90% of the amount you’re betting on – money that you would otherwise have used to buy 100% of the asset – to make other investments. That other 90% is leverage.
Now here’s the kicker. The pension consultant team can prove to you that this is reward without risk. They can prove this because they can show you the past fourty years of betting performance with this interest rate swap, how you always end up ahead by investing in something else with that leverage, how the risk of something going wrong is vanishingly small because the volatility of that interest rate swap has been really low over that entire span of time. Sure, there was a little spike in 2013 with the so-called “taper tantrum”, but nothing you couldn’t handle. They will speak to you about “VAR” and “99% confidence levels”, and you will believe them because the math is correct and who are you to argue with math?
And then the math broke.
And then interest rates went sky-high as the Fed hiked a lot, racing higher in a way that hadn’t been seen in the past 30 years.
And then the next morning, the bank on the other side of the bet emailed you to say that you owe them a lot of money because UK interest rates are going sky-high. And you only have until that afternoon to pay in full. In cash.
This is a “margin call”.
But you don’t have a lot of cash sitting around, so you have to sell some other assets – almost certainly government bonds – to get enough cash together to pay off your bet with the bank. You get a terrible price on the bonds you sell, because their value has gone down as interest rates have gone up. The terrible price gets more and more terrible as the day goes on, as everyone smells the blood in the water. But you survive. You take a gruesome loss on the bonds you had to sell, but you survive.
And then interest rates went sky-higher as Truss and Kwarteng unveiled their goofy plan, racing up in a way that hadn’t been seen … ever.
And then the next morning, the bank on the other side of the bet emails you to say that you owe them a LOT more money because UK interest rates are going even sky-higher.
And you only have until that afternoon to pay in full.
In cash.
But now you have zero cash, so you have to sell a LOT of government bonds to cover that margin call. But yesterday’s terrible price of those bonds is … wait … this can’t be right. This price is impossible.
There are no buyers for these bonds.
None.
No bid.
You’re not going to be able to make the margin call to the bank on the other side of the bet. Which means that you are … ruined. All of the pension assets are now forfeit, because that’s what happens when you can’t make a margin call. The bank will sell your assets at whatever fire sale price they can get.
Because that’s what banks DO.
Congratulations, you turned a long-term investor into a freakin’ hedge fund, and a miserably managed one at that. You killed your pension fund. But hey, your liabilities that will be due in … … twenty freakin’ years …..went down!
This is happening to every pension fund in the country.
This is a Lehman moment.
So, the Bank of England does exactly what they have to do, what they were created to do (other than shape the price of leverage).
They become the buyer of last resort. They pledge infinite money – tens of billions of pounds if required – to buy those UK government bonds that no one else wants to buy and the pension funds have to sell. They bail the pension funds out. And the banks to whom they owed the bet!
Because that’s what central banks DO.
BTW, this last point doesn’t get nearly enough attention. When a government bails out a gambling debt that a big asset owner suffers against a big bank – like when AIG lost tens of billions of dollars in a big bet in 2008 with Goldman Sachs, and the US government paid off that debt – they’re not just bailing out the asset manager, they’re also bailing out the bank.
Anyhoo, that happened last week!!
The pound has stabilized. Gilts have stabilized. Everything has stabilized. Whew! Lehman moment averted. Lesson learned. Glad that’s over!
Except that it’s not.
It will take years to unwind these LDI programs, if they ever are, in fact, unwound. The consultants are hard at work, I’m sure, reassuring everyone that this can’t possibly happen again. More fundamentally, every UK pension fund has taken a series of body blows here. Every UK pension fund has a couple of broken ribs and I’d be surprised if there’s not internal organ damage for some. It always takes a couple of months for the final casualties of these moments to reveal themselves, much less if there’s another shock.
Luckily, the US pension fund world is not quite as reliant on the pure bet method of LDI as the UK pension fund world. There are securities available to US pension funds, like Treasury “strips” where you’re just buying the interest rate promise and not the entire bond, that US pension funds can purchase without leverage in order to accomplish LDI goals without using interest rate swaps.
Wall Street has infected ALL pension funds.
Because that’s what Wall Street DOES.
All I know is that leverage is being repriced, globally.
All I know is that this global repricing of leverage is a wrecking ball around the world, through both interest rates and currencies.
All I know is that what we saw happen in the UK last week is the first shock, not the last, and all the massive pension funds and asset owners who have turned themselves into shadow hedge funds, full of swaps and leverage through the sweet whispers of Wall Street will be our undoing.
“I was surprised to see how much leverage there was in some of those pension plans. And my experience in life has been when you have things like what we’re going through today, there are going to be other surprises. Someone is going to be offsides.”
– Jamie Dimon, CEO, JPMorgan Chase
US Economy
- In real terms, retail sales were higher in September. Despite depressed sentiment and high inflation, consumers are spending.
- Bain expects growth in holiday spending to moderate but remain positive this year.
- Inflation expectations moved higher with gasoline prices this month.
- The GDPNow Q3 growth estimate is near 3% (annualized).
- Economists continue to downgrade next year’s GDP growth (2 charts)
- The first regional manufacturing report of the month shows slowing factory activity.
- Expectations indicators point to a gloomy outlook among the region’s manufacturers.
– Expected shipments:
- Expected business conditions:
- CEO confidence has deteriorated, …
- … as demand growth slows.
- The NAHB homebuilder sentiment continues to deteriorate, with the October figures coming in below consensus.
- Traffic of prospective buyers is crashing.
- Mortgage rates are now the highest in over two decades, …
- Housing valuations, measured in terms of the mortgage payment-to-income ratio, are hitting extreme levels.
- Capital Economics expects home prices to drop 8% on a year-over-year basis (year-over-year housing price declines are unusual).
- The U. Michigan buying conditions for houses have collapsed.
- The market now sees the terminal rate at 5%.
- The 10yr yield keeps rising as well.
- Strong capacity utilization suggests that real rates should be higher.
- Forward-looking indicators are particularly weak.
– Outlook:
- Expected new orders (lowest since 1979):
- The market expects a sharp decline in inflation over the next couple of years.
The Fed
In the latest Hoisington Investments quarterly review, Lacy Hunt describes how Jerome Powell is less comparable to Paul Volcker than some people think. Powell is clearly aligned with Volcker on inflation but not on the role of money. This raises questions on whether the Fed is as committed to price stability as it seems.
- In early 2021 Powell publicly rejected Volcker’s money supply framework, coinciding with the Fed ignoring nearly unprecedented liquidity growth.
- This led to the worst cost of living crisis in 42 years with 180 million Americans seeing lower real wage income.
- The Fed is now working to reverse the 2020-21 explosion in reserves.
- Surging, then reversing money supply combined with very low velocity has several negative consequences.
- One of them is that the pool of US dollars outside the US is shrinking, causing a global liquidity shortage.
- Leading indicators point to future economic weakness even though GDP is currently improving.
If the Fed fails to stay on course, the emerging money/price/wage spiral could become entrenched, leading to 1970s-like pain. The Fed’s mettle will be tested because some over-leveraged institutions will certainly fail in this situation.
Market Data
- The S&P 500 closing above the 200-week moving average.
- Leading indicators continue to signal weaker earnings ahead.
- Fund managers are sitting on a lot of cash.
- The Philly Fed’s manufacturing index (forward-looking vs. lagging components) points to a crash in corporate earnings.
Quote of the Week
The only way to keep your health is to eat what you don’t want, drink what you don’t like, and do what you’d rather not. – Mark Twain
Picture of the Week
All content is the opinion of Brian J. Decker
