ALEX BRUMMER: The Bank of England ignored its own alert on LDI and has exposed superannuation funds to frightening risks
The cautionary note explaining the Bank of England’s extraordinary £65bn bond market bailout appears on page 54 of its November 2018 Financial Stability Report.
He argues that it is “unclear” whether pension funds and insurers pay enough attention to the liquidity risks involved in using liability-driven investment (LDI) programs aimed at improving gilt returns.
The Bank has committed to working with other implementers: the Prudential Regulation Authority (an arm of the Bank), the Pensions Regulator and the Financial Conduct Authority, to monitor all the things that could go wrong, from lack of cash to losses due to lack of funds. credit or bank leverage.
Out of focus: By allowing the gap between US Treasury bond yields and UK gilts to widen, the Bank of England’s interest rate-setting Monetary Policy Committee left a target open
So everything went well!
Four years after the Bank’s sotto voce warning, the taxpayer has been forced to rescue a life savings and pension market of 10 million people. It shouldn’t have been hard to see this coming.
City players BlackRock, Schroders, Legal & General and others invented a wonderful tool, using borrowed money, derivatives and other techniques, to improve the performance of gilt portfolios.
Paradoxically, the objective was to strengthen the financing of private sector pensions, many of which were in deficit. It took off like a rocket and markets tripled in a decade to £1.5 trillion.
Lord (Simon) Wolfson, Britain’s most impressive retailer, says he was so concerned about the financial sector’s love affair with ILDs, having attended many sales pitches, that he wrote to the Bank of England in 2017, suggesting actions to address the risk.
As was the case in the years leading up to the financial crisis and the Libor rate-fixing scandal, the Bank’s ability to process intelligence and do something about it was poor.
Only faced with the prospect of a cascade of insolvencies in the financial system, affecting the entire pension structure, did he go to the Treasury and launch a lifeboat, having first obtained compensation.
The same bank that has been strangely reluctant to unwind EU regulation, fearing that pension funds and insurers might invest in risky assets like infrastructure, had a potential catastrophe under its nose.
The Bank can correctly point to some extraordinary conditions, with the pound under pressure and the value of the long 30-year gilt plummeting.
None of these could have happened if the Monetary Policy Committee (MPC) that sets interest rates had been bolder at its September meeting.
Members may not have been fully appraised of Foreign Minister Kwasi Kwarteng’s supply-side tilt, but they were aware that the Federal Reserve had raised interest rates by three-quarters of a percentage point.
The US central bank has moved decisively to squash a rate of inflation caused in part by money profligacy. By allowing the gap between UK gilt yields and US Treasuries to widen, the MPC left an open target that was plundered by traders.
But no one should think that the current bond tantrum is a uniquely British problem. As the FT reported this week, the much larger and more important US bond market, valued at $24 trillion, has recently been hit by the biggest turbulence since Covid-19. It then required large-scale interventions from the Federal Reserve to prevent the entire financial system from blowing up.
Andrew Bailey, the governor of the Bank of England, played a role then (as now) in joining other central banks in launching dollar-swap deals designed to prop up confidence.
The tantrums of the bond market, and the fire and brimstone of the Federal Reserve and other central banks are exaggerated in the opinion of veteran monetarist Patrick Minford.
Monetary expansion on both sides of the Atlantic has been reduced to zero, and as the global economy slows and falls into recession, inflation will dissipate as quickly as it started. Minford forecasts that UK consumer prices will fall 5 percent next year, a striking argument that goes against the current consensus of Wall Street and City stockbrokers.
Herd instinct in financial markets has undermined ILD strategies for pension funds.
And careless and unfocused regulation by the Bank of England and others exposed superannuation funds to frightening risks.