The Gilt Debacle: How unsound policy led to pension fund instability and its implications for future policy challenges
On the 23rd of September 2022, the then-newly appointed Prime Minister Liz Truss and the Chancellor of the Exchequer, Kwasi Kwarteng, announced their mini-budget, a stimulus plan designed to enable economic growth and support British households in the context of a cost-of-living crisis. Indeed, the Mini Budget contained tax cuts and energy bill support, which would necessitate a 72-billion-pound rise in gilt sales in 2022. To many, this policy proposition may seem intuitive; however, it must be considered within the broader economic backdrop. In effect, given inflation and the tightening cycles of the Bank of England, loose fiscal policy characterized by the Mini Budget’s 45 billion pounds in unfunded tax cuts seemed counterproductive, and investors were quick to cast their vote of no confidence.
Faced with the prospect of higher inflation and interest rates, UK traders sold gilts “en masse,” leading to the highest one-day yield increase of a five-year gilt on record. The 23rd marked an uncharacteristically volatile day for all traders in this market; however, for pension funds utilizing Liability Driven Investments strategies, the Mini Budget sparked an unprecedented panic.
Liability Driven Investments (LDI) are a strategy that uses derivatives for leverage, enabling the funds to match current assets to liabilities, thus avoiding a shortfall in funds used to pay pensioners. However, this leverage not only comes at the price of the contract, but the leveraged party also must post collateral acting as a form of insurance to the counterparty. This collateral rises and falls with the value of the underlying asset it tracks. These strategies operate soundly in environments of predictable volatility but come under strain given unpredictable events.
Interest Rate Swaps illustrate the fragility of these strategies in the context of the gilt crisis. Swaps create benefits through either an increase or a decrease in rates. In an interest rate swap, one party agrees to pay a floating rate, equated to a benchmark interest rate, whereas the other party receives a fixed rate pre-determined before entering into the swap agreement. LDI pension schemes often hedge against a decrease in interest rates by entering a swap on the fixed rate side. Thus, as the interest rate increases, the pension scheme is required to post collateral as insurance against insolvency.
These mechanisms came under stress with the announcement of Truss’s Mini Budget. As traders sold their gilts, yields skyrocketed. With this increase in yields, the schemes holding the fixed-rate side of the swap were required to post collateral. However, this sort of volatility in the gilt market was unprecedented, and schemes did not have sufficient cash on hand to post the required collateral. Indeed, the moves were so sudden and large that some collateral calls, ones that normally would have allocated investors several days or weeks before a due date, now demanded posting in a matter of hours. Without sufficient cash, funds were forced to sell their most liquid assets, leading to a “death spiral” of gilts that continued to raise yields and thus require further postings of collateral. This cycle necessitated an intervention from the Bank of England, as there were soon not enough buyers for the gilts sold, a clear sign of an impending liquidity crisis.
This Mini Budget led to the resignation of both Liz Truss and Kwasi Kwarteng, who was replaced by Rishi Sunak and Robert Hunt. Some market participants believe this crisis has underlined the failure of financial institutions to manage risks, leading to calls for increased oversight and regulation. For others, this catastrophe also represents a failure of certain branches of government to work in unison with one another. Indeed, adequate coordination of monetary and fiscal policy is key to tackling inflation. However, in the case of the Mini-Budget, it would be an understatement to say that central banking and fiscal policy were at odds.
The Gilt Debacle is indicative of the challenges policymakers face. Politicians are often criticized and are at the mercy of public opinion, which incentivizes the implementation of policies that are only viable in the short term. Policymakers may seek solutions that soothe the pain of inflation in the short term but lead to disastrous situations long term. Truss set the Mini Budget in motion to stimulate economic investment and to help households as well as firms cope with rising enrgy costs; its intentions were noble, but its implementation ran directly counter to the Bank of England’s anti-inflammatory monetary policy. Further, the plan also included substantial tax cuts for households and most notably Britain’s upper crust that would deplete government tax revenue. While the BoE raised rates and planned for further quantitative tightening to cool down its inflating economy, Truss’s announcement to spur growth led to nefarious effects.
The British political class need not be the only victim of the incentive to focus on the short term. For instance, the ECB also has a dilemma on its hands regarding Italian debt. The ECB could raise interest rates to help fight inflation in the Eurozone and put further strain on Italian debt. On the other hand, it may decide to help at-risk members such as Italy and raise rates less aggressively. It could also provide support to the debt of struggling members by buying bonds, although such action might encourage irresponsible fiscal policies and penalize more fiscally conservative EU members.
Another example hits even closer to home: in November, the Quebec government announced measures to give out $600 CAD cheques for those making less than 50,000 CAD per year, at the risk of worsening inflation by further boosting demand. In short, combatting inflation takes political courage. The question remains whether governments can balance these economic objectives with their alternative political ones.