The mini-budget on 23rd September was an earthquake for the UK economy, leaving financial markets questioning the new government’s economic credibility and its ability to deliver growth in the long run.
It wasn’t just the package of £45bn in unfunded tax cuts, expected to deliver little economic growth while raising debt interest costs significantly, that spooked markets. The charge sheet also included sacking HM Treasury’s Permanent Secretary, the Chancellor’s promise of further tax cuts, the failure to allow the OBR to produce an independent assessment, and questions raised by Liz Truss about the Bank of England’s mandate.
On the morning of 26th September, market doubts turned into a record low for the pound and into rapidly rising interest rates (yields) on UK government bonds (gilts). UK pension funds and mortgage markets were left struggling to adjust to the rapid rise in interest rates and market volatility.
The most acute pressure was felt in pension funds, leading the Financial Policy Committee (FPC) of the Bank of England (BoE) to commit up to £65bn over 13 days to stabilise the gilt market and prevent wider financial instability.
Why were pension funds the source of potentially systemic problems?
As interest rates fell over the past two decades, defined benefit schemes in the UK found that the accounting value of their liabilities (the amount pensions owe people both now and in the future) started to rise: when interest rates on government bonds fall, funds’ future obligations are discounted at a lower rate, thus raising the present value of those longer-term obligations. The Pensions Regulator estimates that every 0.1 percentage point fall in interest rates on government bonds increases the obligations of UK pensions funds by at least £23bn.
While rising interest should have made pension funds’ long-term obligations more affordable, they also had a side effect that not only limited this upside but also created significant cash flow problems for pension funds.
This liquidity problem stems from the investment strategies – called liability-driven investments (LDI) – that pension funds adopted to protect themselves from falling interest rates. LDI seeks to ensure that a fund’s assets match its long-term funding obligations by allocating part of the portfolio to high-growth investments and part of the portfolio to government and corporate bonds. These bonds are then leveraged via interest rate swaps to protect the pension fund valuations from swings in interest rates.
It’s these latter hedging strategies that have created trouble for pension funds: pension funds used interest rate swaps to buy access to a stream of fixed-rate interest payments that were tailored to match their obligations, and in return agreed to provide a stream of variable interest payments to the other party. Not only do pensions’ bonds act as collateral for these leveraged investments, funds are also required to set aside additional collateral if variable interest rates rise too high.
As interest rates on UK government bonds rose sharply at the beginning of last week, pension funds were increasingly being asked to post additional collateral for the interest rate (and inflation) swaps that formed part of their LDI strategies. Pension funds were not insolvent, they were just illiquid: they didn’t have enough assets or cash to meet the collateral demands. To raise funds for the additional collateral, pension funds then sold assets, primarily government bonds, pushing down gilt prices and pushing up their interest rates. But the cycle of higher interest rates and falling gilt prices led to more demands for collateral, creating what markets call a self-reinforcing ‘doom loop’.
This growing financial instability came to a head on 28th September when the FPC decided it needed to step in. This intervention has proved effective at shoring up gilts without the BoE having to make the maximum intervention: long-dated gilt yields have fallen even though, as of 3rd October, the BoE had bought only £3.7bn in long-term gilts.
Mortgage markets, on the other hand, are still reeling from rises to the short-term gilt rates used to price mortgages. As rates rose sharply on 28th September, mortgage providers found that newly agreed deals were rapidly becoming unprofitable, especially for smaller banks operating on fine margins. Providers began withdrawing mortgages, leaving would-be home buyers in the lurch, and raising the prospect of a collapse in house prices.
As of 3rd October, almost 1,700 or 42% of mortgage products had been withdrawn from the UK market as mortgage provider struggled to price products in the wake of market volatility. Interest rates on two-year fixed mortgages are up a full percentage point compared with a fortnight ago, and with 1.8mn households due to come off fixed-term mortgages next year, the full economic pain of the shift in the mortgage market is yet to be felt.
Markets have stabilised as the government’s u-turn on the unfunded 45p rate cut and its decision to bring forward the OBR assessment have signalled a helpful shift away from its cavalier approach to economic policy making. This means that, barring any further surprises from the government, the BoE should be able to withdraw its temporary support for long-dated government bonds on 14th October as planned without seeing a return to instability.
Beyond these immediate aftershocks of the mini-budget, the longer-running challenges of economic credibility and competitiveness remain. The unfunded tax cuts have proved to be all pain with little economic gain. In addition, the government no longer has the political capital to deliver either its proposed supply side reforms or the deep, painful spending cuts needed to fund their tax cuts if the OBR does not accept that a change in growth rates is now in prospect.
The pressure on pensions has only abated, not disappeared, and the mortgage pain is only beginning. Markets abhor a vacuum, and in the absence of a clear and credible path forward from the government on growth and the public finances, the UK is likely to continue to suffer from the fallout of the disastrous mini-budget.