Global de-risking/deleveraging has taken A Threatening Turn. It’s no exaggeration to write that the UK pension system was this week at the brink of spectacular collapse, with confidence in policy and market function hanging in the balance.
September 28 – Reuters (David Milliken, Carolyn Cohn, Sachin Ravikumar and Dhara Ranasinghe): “The Bank of England stepped into Britain’s bond market to stem a market rout, pledging to buy around 65 billion pounds ($69bn) of long-dated gilts after the new government’s tax cut plans triggered the biggest sell-off in decades. Citing potential risks to the stability of the financial system, the BoE also delayed… the start of a programme to sell down its 838 billion pounds ($891bn) of government bond holdings, which had been due to begin next week. ‘Were dysfunction in this market to continue or worsen, there would be a material risk to UK financial stability,’ the BoE said. ‘This would lead to an unwarranted tightening of financing conditions and a reduction of the flow of credit to the real economy.’”
While not mentioned specifically in the Bank of England (BOE) statement, various reports pointed to massive pension system margin calls and a resulting disorderly UK government bond (“gilts”) market. From the FT: “‘At some point this morning I was worried this was the beginning of the end,’ said a senior London-based banker, adding that at one point on Wednesday morning there were no buyers of long-dated UK gilts. ‘It was not quite a Lehman moment. But it got close.’”
From Bloomberg: “The size of the LDI (liability-driven investing) market has exploded over the past decade. The amount of liabilities held by UK pension funds that have been hedged with LDI strategies has tripled in size to £1.5 trillion ($1.7TN) in the 10 years through 2020.”
September 29 – Wall Street Journal (Jean Eaglesham, Heather Gillers, Leslie Scism and Caitlin Ostroff): “A pension-fund strategy that aims to reduce volatility without lowering returns created the first crack in the financial system after one of the fastest jumps in interest rates in decades. The Bank of England stopped the selloff exacerbated by heavy selling from U.K. pension funds forced to raise cash. The strategy is resulting in more modest selling in the U.S. as pension funds needed to increase collateral. Pension funds adopted the so-called liability-driven investment strategy, or LDI, to address regulatory changes and help to close the gap between assets and liabilities. But the strategy faltered as interest rates surged and bond prices fell, forcing more selling and driving prices still lower. ‘A vicious cycle kicks in and pension funds are selling and selling,’ said Calum Mackenzie, an investment partner at pension-fund adviser Aon PLC. ‘What you start to see is a death spiral’… Some of the more than $1.8 trillion worth of corporate pension plans in the U.S. are also facing margin calls.”
Attention was this week focused on “liability-driven investment strategies” – or LDI: “A strategy used by pension funds to manage their assets to ensure they can meet future liabilities.” And over recent years, an already challenging endeavor was made almost unworkable. Years of zero rates forced pension fund managers to reach for yields, derivatives, and leverage to generate sufficient returns to match future obligations.
Of course, an always enterprising “Wall Street” was there with a bevy of sophisticated strategies and derivative products to seemingly solve any problem. And, sure enough, everything worked splendidly – so long as rates and market yields remained ultra-low. Popularity ensured the entire strategy became one big – and now unruly – Crowded Trade.
As the BOE began to raise rates and market yields surged higher, trouble quickly materialized. Some levered pension funds sold gilts, pushing yields higher still. The pension system had become a major player in the derivatives interest-rate “swaps” marketplace over the years. And as yields surged higher, losses on swap positions required additional collateral to meet margin calls. A shortage of collateral ensued, with many fund strategies left without interest-rate hedges.
The new UK government’s tax cuts and subsidies announcement hit an acutely vulnerable marketplace, with gilt yields immediately spiking higher in a dislocated market. The highly levered pension funds were at risk of disorderly liquidations, while interest-rate derivatives markets faced catastrophic margin calls in an illiquid and collapsing marketplace.
The Bank of England aggressively intervened, in what is essentially a short-term QE program. Many in the UK are on tenterhooks, fearing a return of instability, with the scheduled conclusion of this program on Wednesday, October 14th. Understandably, others are uncomfortable with additional QE in such a high inflation backdrop.
Market Structure has been an overarching CBB theme. The UK pension scheme blowup provides an early example of an untenable strategy that seemingly functioned well in the previous cycle’s backdrop (zero rates, liquidity abundance and reliable central bank market backstops).
Now, an unsettled new cycle unfolds. Leverage has become toxic, a development with far-reaching ramifications. Moreover, derivatives strategies that have assumed liquid and continuous markets now face an illiquid and discontinuous world. There are scores of festering untenable strategies out there – at home and abroad.Trillions upon Trillions. Dominos. Contagion looks like a sure bet.
The UK is only the first pension system facing the harsh reality of a steep devaluation of assets and the prospect of widespread insolvencies (liabilities greatly exceeding assets).
FT headline: “The Week That Wrecked Our Personal Finances in the UK.” It’s important to appreciate that UK “personal finances” were not wrecked this week. And you’re not going to wreck the UK pension system in a week’s time. The wrecking (ball) has been ongoing for years and even decades. For too long, misguided policy focus has been on inflating the value of bonds, stocks and other financial assets. A momentous gap developed between the perceived value of financial assets and the true economic value of assets underpinning UK (and global) pensions and personal finances. This week was about a disorderly adjustment in grossly inflated UK bond values and associated panic. These types of adjustments are brutally destabilizing.
Many analysts were convinced the so-called “great financial crisis” would have been avoided had the Federal Reserve only moved early to bail out Lehman Brothers. But that misses the crucial analysis of Trillions of mispriced securities and derivatives (especially in the mortgage universe). The chasm between market/perceived values of financial assets and real economic wealth/wealth-creating capacity has ballooned tremendously over the past 13 years. Bubbles eventually burst, with a highly disruptive adjustment process becoming unavoidable.
We can simplistically break down the unfolding Market Structure predicament into three general issues: 1) Financial asset overvaluation not well supported by underlying economic wealth. 2) Over-leverage. 3) Risk engineering, transfer and management.
There is today gross financial asset overvaluation virtually across the board. Bond and fixed-income markets have not yet fully revalued in response to inflation dynamics, over-indebtedness, and new central bank policy regimes. Corporate debt has barely begun to price in a historic cyclical downturn and associated systemic Credit impairment. Equities are early in adjusting to an extremely high-risk world of Credit market instability, economic vulnerability, geopolitical peril, policy impotence, climate change, and likely an earnings collapse.
As for leverage, I believe the global system is only in the earliest deleveraging phase. The world is being forced to adjust to an unfolding cycle with myriad extraordinary uncertainties. Previous cycle typical leverage metrics are today (and for the foreseeable future) untenable. Pension funds are only one segment of highly levered market, financial and economic systems.
It is the “risk engineering, transfer and management” facet of the analysis that these days is somewhat the big unknown. I worry about derivatives and structured finance more generally. Recall the collapsing values of “AAA” mortgage securities during the bursting of the mortgage finance Bubble. Investors and regulators were quick to blame the ratings agencies, when it should have been obvious to anyone doing real analysis that transforming Trillions of risky late-cycle mortgage Credit into mostly top-rated securities was fanciful financial alchemy. And it is the sudden loss of confidence in perceived safe and liquid instruments that sparks panics and runs.
Throughout the protracted post-2008 boom cycle, there was a proliferation of instruments and strategies that mask underlying risks. Myriad risks (i.e. rates, Credit, currency, market, etc.) are shifted, transformed and often obfuscated. In the case of the UK pension funds, many “LDI” strategies incorporated derivatives hedges that were to protect against higher market yields. But when yields spiked higher, it became too expensive (required too much additional collateral) to maintain the hedges. This should be viewed as an early warning that many hedges will not operate as expected in the unfolding highly unstable market environment.
Importantly, too many hedges rely on dynamic/“delta” trading strategies that are forced to sell instruments into rapidly declining and liquidity-challenged markets. I’ll assume this is a major issue in the UK pension bond debacle.
UK 10-year yields traded to 4.59% in early Wednesday trading, up an astounding 146 bps in seven sessions, before reversing sharply lower (BOE intervention) to close the session at 4.01%. Ten-year Treasury yields rose to 4.01% Wednesday (up 52bps in seven sessions), only to end the day at 3.73%.
Why, one might ask, was the UK pension issue causing such a ruckus in U.S. and global markets? First, liquidity is fungible globally, with de-risking/deleveraging dynamics sparking a rush for liquidity throughout international markets. Moreover, Market Structure issues are a global phenomenon. The same financial engineering used by UK pensions has been adopted in the U.S. and worldwide. The hundreds of Trillions interest-rate swaps derivatives markets are global and tightly interconnected. If a strategy falters in one market, kindred strategies are then in the crosshairs globally. A problem structure in any country quickly becomes a concern for all markets. And when blowups and panics spark illiquidity and discontinuity in one market, immediately all markets are on guard for similar blowups. When it comes to Market Structure, it is one monstrous global speculative Bubble.
Global “risk off” deleveraging attained powerful momentum this week. It appeared decisive. And that the BOE intervention rally had such a short (one session) half-life was ominous. Such highly synchronized global markets are ominous. And that Treasuries can’t catch even an itty bitty safe haven bid in the face of such acute global stress is further evidence of ominous new cycle dynamics.
The rundown. Chinese “big four” bank CDS spiked further to multi-year highs. Industrial & Commercial Bank of China (ICBC) CDS jumped another 17 to 137 bps (42bps 2-wk gain). China Construction Bank CDS rose 14 to 141 bps (46bps 2-wk gain). Bank of China CDS rose 17 to 136 bps (42bps 2-wk gain), and China Development Bank CDS jumped 15 to 125 bps (39bps 2-wk gain).
China sovereign CDS gained 10 this week to 112 bps, with a notable two-week gain of 37 bps – to the high since January 2017. Number one builder Country Garden bond yields surged almost nine percentage points to 46%. The yield for China’s high-yield dollar bond index jumped over 200 bps this week to 25.25%, as Asian high-yield bond yields jumped 133 bps to 17.54% (almost back to the July spike high). Asian currencies performed poorly, with the South Korean won down 1.5%, the Malaysian ringgit 1.3%, the Indonesia rupiah 1.3%, and the Japanese yen 1.0%. Heightened concerns for debt and leverage bode poorly for China and greater Asia.
Emerging Market CDS jumped 14 bps this week to a two-month high 331 bps (began the year at 187bps). The Russian ruble declined 3.8%, the Colombian peso 3.5%, the Hungarian forint 3.0%, the Brazilian real 2.8% and the Peruvian sol 1.8%. Ten-year yields spiked 73 bps in Poland, 62 bps in Croatia, 52 bps in Hungary, 43 bps in Czech Republic, 41 bps in Peru, 35 bps in Lithuania, and 33 bps in Romania. Dollar-denominated EM bond yields continue to spike higher. Yields were up 29 bps in Panama, 23 bps in Indonesia, 21 bps in Saudi Arabia and 13 bps in the Philippines. CDS spiked 32 bps in Brazil and 31 bps in Colombia.
It was another alarming week for global bank CDS. Credit Suisse CDS surged 32 bps to a record 254 bps. It’s worth noting that Credit Suisse CDS remained below 200 bps throughout the 2008 crisis, spiking to 150 bps during the March 2020 panic. UK banks NatWest (plus 16), Lloyds (12), and Barclays (11) all posted double-digit CDS gains. Citigroup CDS jumped 10 to 134 bps – the high since March 2020. JPMorgan CDS rose five (to 111bps), Bank of America nine (116bps), Morgan Stanley eight (131bps) and Goldman Sachs five (135 bps) – all highs since the pandemic panic.
U.S. high-yield CDS surged 42 to 610 bps, trading this week to the high since May 2020. Investment-grade CDS added two to 108 bps, also the high since the pandemic crisis period. The VIX traded to 35, the high since the June spike. The bond volatility MOVE index surged to almost 160, just below the March 2020 spike high.
September 30 – Bloomberg (Olivia Raimonde and Carmen Arroyo): “Credit markets are starting to buckle under pressure from soaring yields and fund outflows, leaving strategists fearing a rupture as the economy slows. Banks this week had to pull a $4 billion leveraged buyout financing, while investors pushed back on a risky bankruptcy exit deal and buyers of repacked loans went on strike. But the pain was not confined to junk — investment-grade debt funds saw one of the biggest cash withdrawals ever and spreads flared to the widest since 2020, following the worst third quarter returns since 2008. ‘The market is dislocated and financial stability is at risk,’ said Tracy Chen, portfolio manager at Brandywine Global Investment. ‘Investors are going to test central bank resolve,’ she said…”
Some this week questioned whether the UK had become an “emerging market.” The nation’s deficits, debt level and Current Account Deficit are, after all, symptomatic of typical EM crisis fragility. But it has been how EM countries were forced to respond to crisis dynamics that set them apart from their “developed” neighbors. EM countries invariably are forced to aggressively hike interest rates to stabilize collapsing currencies and debt markets. Developed countries, on the other hand, have for years enjoyed the luxury of collapsing interest rates and even massive “money” printing operations during crisis environments to bolster asset markets and economies.
The UK is A Test Case right now. High inflation and acute currency fragility seem to preclude the normal pivot to aggressive rate cuts and yet another round of “easy money.” We’ve already witnessed the usual shift to fiscal stimulus get shot down in flames. The jury is out on the BOE’s emergency bond support operations. Indeed, the UK is now one yield spike and/or currency drop away from a debilitating crisis of confidence. The United Kingdom is not unique.
If markets block the UK’s use of monetary stimulus to thwart crisis dynamics, it’s a whole new ballgame. Unleashed Market Structure issues (certainly including illiquidity, market dislocation, and derivatives counter-party risks) would be difficult to contain, with crisis of confidence dynamics likely demonstrating powerful global contagion.
If phenomenal global financial market risks weren’t enough, disturbing geopolitical risks are also intensifying.
September 30 – Financial Times (Max Seddon and Roman Olearchyk): “Vladimir Putin has annexed four regions in south-eastern Ukraine and vowed to use ‘all the means’ at Russia’s disposal to defend the territory in a speech that marked a further escalation in his war against Kyiv and his resentment at its western allies. In a ceremony marking the move on Friday, the Russian president called on Ukraine to negotiate an end to the war — but reserved his strongest ire for Kyiv’s ‘real masters’ in the west, which he accused of trying to ‘destroy’ Russia. The annexations are a dramatic attempt to raise the stakes in the conflict by bringing them under Russia’s nuclear umbrella… Putin said an attack on the four regions, which he said he now considered to be part of his country’s territory, would be treated as an attack on Russia and met with full force. ‘We will defend our lands with all the means at our disposal and do everything to protect our people. This is our great liberating mission,’ he said… Although Putin did not make any reference to Russia’s own nuclear arsenal, which he had threatened to use when he announced the annexations last week, he accused the US of setting a ‘precedent’ in bombing Hiroshima and Nagasaki at the end of the second world war. But the bulk of the president’s speech was spent ranting against the west. It covered topics as varied as western sanctions, European imperial history, crude jokes about sex change operations and accusations that ‘Anglo-Saxons’ had attacked two gas pipelines in the Baltic this week… ‘They are blatantly dividing the world into their vassals and everyone else,’ Putin said… ‘The west is looking for new ways to strike against our country, to weaken and destroy Russia… They just can’t put up with there being such a big country with its territory, rich natural resources, and people who won’t live by anyone else’s rules’… Putin offered hope the EU would drop its support for Ukraine as it steels itself for a difficult winter without Russian energy supplies. ‘Politicians in Europe will have to convince their citizens to wash less and heat their homes themselves. And when asked why they point their fingers at Russia… You can’t feed people with paper dollars and euros… You can’t warm people with puffed-up valuations — you need energy sources.’”