We have witnessed extraordinary times in British politics over the last eight weeks with three prime Ministers and 3 Chancellors – historic and unprecedented. There has been tremendous turbulence in the capital markets – a rollercoaster ride as a result of inconsistency between fiscal & monetary authorities.
On September 23rd, Liz Truss’s finance minister Kwasi Kwarteng announced billions of pounds of tax cuts, setting off a chain reaction of events. Given that the announced tax cuts were inflationary, unfunded, and poorly communicated triggered a significant sell-off in British government bonds (gilts).
This sell-off, in turn, triggered calls for additional cash collateral to be put up by many of Britain’s defined benefit pension schemes which total approximately £2trillion. Many pension schemes hedge their positions by buying derivatives on gilts managed by liability-driven-investment (LDI) funds.
Given the sharp move in gilts, these LDI funds gave margin calls to the pension schemes. These pension schemes would then have to sell their gilt positions or have their derivative exposure sold off. Both actions could create significant downward pressure on gilts.
To give the pension schemes some breathing room, so to speak, the Bank of England (BoE) intervened with an emergency £65b bond-buying programme to stabilise the market. This programme continued until October 14th. The affected pension schemes would have preferred this to last longer. As an additional measure, the BoE has also provided a new collateral facility to ease any further liquidity problems the pension funds face.
The announcements of the Truss government were inflationary at the same time the BoE was raising interest rates and pursuing quantitative tightening (QT) to rein in double-digit inflation in the UK. After a four-week pause in QT due to this pension scheme LDI crisis, the BoE is set to resume its tightening of monetary policy from November 1st onwards following the release of the remainder of the fiscal statement by the new chancellor, Jeremy Hunt, in November.
With the almost complete rollback by Jeremy Hunt of Kwarteng and Truss’s ‘Mini Budget’, the market position has virtually returned to its original position pre-September 23rd. The combined team of the new Prime Minister, Rishi Sunak, & Mr Hunt, following Liz Truss’s departure, have helped to stabilise the gilts market and Sterling.
The markets are optimistic that they will exercise much-needed fiscal discipline and responsibility to continue the same trajectory after this great period of instability.
However, Trussonomics has been a valuable lesson for governments worldwide who wish to pursue an ideological led fiscal policy over more objective economic policies appropriate for the time and circumstances.
Please contact us if you have any questions about the markets or your investments.