“Lehman moment” avoided?

Last week, the Bank of England took emergency action to avoid a meltdown in the UK pensions sector, unleashing a £65bn bond-buying programme to stem a crisis in government debt markets. It all started after the government announced a new tax cut and spending program, which led to yields on 30-year gilts to rise rapidly above 5%, a 20-year high and the fastest monthly increase since 1957.

The daily move in long term gilts was unprecedented with investment banks insisting the BOE intervene. The expectation was that if there was no intervention, gilt yields could have gone up to 7-8% from 4.5% in the morning and given the scenario around 90% of UK pension funds would have run out of collateral.

Insurers and pension managers use an investment strategy known as liability-driven investing, or LDI. It’s designed to lower the risk that liabilities (ex: amounts being paid or expected to be paid out in pensions) too greatly exceed assets (investments tasked with the capability to cover those liabilities). Most LDI’s rely on government debt and leverage. If markets behave somewhat normally, everything works as planned, however, when a black swan appears, things can go awry, which appears to have been the case last week.

After it’s intervention, the BOE pledged to buy long-dated bonds at a rate of up to £5bn a day for the next 13 weekdays.  The government also U-turned on plans to scrap the 45p rate of income tax for higher earners.  While the idea of the plan was to boost economic growth, the economy is now facing the prospects of increased inflation due to the BOE’s intervention, at least in the short term.