The BOE acted last week because it feared £50bn of gilt sales were about to hit a market which normally trades around £12bn of long gilts a day, according to a unexpectedly interesting letter from Sir Jon Cunliffe, the BOE’s Deputy Governor, Financial Stability to the Treasury Select Committee, released today (link).
However, the letter doesn't address why the BOE didn't act when pension consultants began issuing firm warnings about the risk from June 2022 (see Total Derivatives) with traders wondering about the impact of margin calls on gilts in July (Total Derivatives).
As the letter notes, the BOE's backstop has shrunk gilts' 'liquidity premium' from the scary levels hit on Wednesday morning. Still, 30y nominal yields are up another 13bps today, taking the spread over 30y Bund yields to around 230bps versus 170bps from before the collateral carnage. And 30y real yields are another 20bps higher on the day.
Cunliffe sets out the timeline of events in the run-up to the BOE’s intervention, which began when the Bank’s ‘market intelligence calls’ identified “the first concerns from LDI fund managers about the implications of market developments, should they persist” following the Chancellor's bungled Budget.
Through Monday September 26, the Bank got market intelligence of "increasing severity from a range of market participants”, and in particular from LDI fund managers, reporting that “conditions in core markets, should they continue to worsen, would force them to sell large quantities of long-term gilts in an increasingly illiquid market.”
The BOE continues: “Taken at face value, this market intelligence would have implied additional long-term gilt sales of at least £50 billion in a short space of time, as compared to recent average market trading volumes of just £12 billion per day in these maturity sectors.”
By the end of Tuesday September 27, the Bank was informed by “a number” of LDI fund managers (the market is dominated by BlackRock, Insight and L&G) that, “at the prevailing yields, multiple LDI funds...would have to begin the process of winding up the following morning. In that eventuality, a large quantity of gilts, held as collateral by banks that had lent to these LDI funds, was likely to be sold on the market, driving a potentially self-reinforcing spiral and threatening severe disruption of core funding markets and consequent widespread financial instability.”
The BOE points out that its Financial Policy Committee had previously assessed the capacity of the biggest derivatives users among UK pension schemes to cover the posting of variation margin calls on OTC interest rate derivatives from a 100bps jump in rates along the curve. However, 30y gilts moved in a 127bps range on September 28 alone, “ higher than the annual range for 30 year gilts in all but 4 of the last 27 years," according to the BOE today.
What about the future? On emergency QE, the BOE says that:
- “The duration of the operation is intended to give LDI funds time to build the necessary resilience, as noted earlier. As explained above, the LDI funds either need to inject capital from their DB pension fund investors or sell assets to reduce their leverage.”
- ”Given prevailing turnover, it was judged that £5 billion a day was likely to be more than sufficient, providing a credible backstop capacity. The Bank keeps the parameters of the auctions under review in light of prevailing market conditions and the calibration of the tool as a backstop. In the event, partly reflecting the credibility of the backstop, actual purchases have been well within the £5 billion limit.
- “The Bank is studying market conditions and patterns of demand and will continue to use reserve pricing in order to ensure the backstop objective of the tool is delivered.”
- ”Once the purchase programme is complete, the operation will be unwound in a smooth and orderly fashion once risks to market functioning are judged by the Bank to have subsided. The approach to unwind will depend, among other things, on the scale of actual purchases, the market conditions during those purchases and the market conditions when the purchases end. “
- “These operations are not intended to create central bank money on a lasting basis, nor are they designed to cap or control long-term interest rates. Their intention is instead to ensure that those yields are not distorted by severe liquidity strains in financial markets. As such, they should not shift the underlying monetary trends in the economy.”
As for the future regulation of LDI:
- “The Bank, The Pensions Regulator and the Financial Conduct Authority are closely monitoring the progress of LDI funds as they take action to put their positions on a sustainable footing for whatever level of asset prices prevails at the end of the operation and to ensure LDI funds are better prepared for future stresses given the current volatility in the market. While it might not be reasonable to expect market participants to insure against all extreme market outcomes, it is important that lessons are learned and appropriate levels of resilience ensured.”