What a wild week. The turmoil in UK markets escalated far beyond what anyone could have expected even after the government revealed a remarkably ill-judged mini-Budget last Friday.
Stepping back to behold the detritus, some things are becoming a little clearer. Some of the scale of the recent UK government bond market collapse is explained by a “doom-loop” triggered by pension fund gilt selling. This escalated calls on funds to post collateral on derivative trades struck, ironically, to hedge their liabilities. In turn, this triggered more selling. However, the answers to many questions remain murky.
For example, just how did so many pension plans mess up their risk management so badly, how close to the brink did they actually come, and where do we go from here? Is the current uneasy calm bought by the Bank of England’s intervention durable without the UK government shifting its fiscal stance — or at least appearing willing to listen to the market’s screams?
But importantly, some old lessons unfortunately forgotten are also being relearned. First and foremost, that in finance there is nothing quite so dangerous as a supposedly safe strategy.
After years of worrying over high-frequency trading, dodgy corporate debt, meme stock frenzies, China’s imploding real estate market and leveraged hedge funds, it turns out that one of the biggest risks lay hidden within an obscure risk-management strategy pursued mostly by UK defined benefit pension plans.
Frankly, it is hard to think of something duller than liability-driven investing. Even many finance industry insiders would have glazed over if you tried to explain the numbing actuarial nuances. This is no flashy hedge fund strategy, or daring bond king bet gone horribly awry. It is the financial market equivalent of doing your family taxes.
But it hammers home a truism from many previous market calamities, including the global financial crisis of 2008: the greatest damage is often caused by supposedly stolid investments that turned out to be anything but, rather than nakedly risky bets.
When investors buy junk bonds or emerging market stocks, they should know there are potential downsides. It’s still painful when things go wrong, but it’s hardly a shock when risky assets turn out to be, well, risky. You get on a rollercoaster knowing it will be a bumpy ride.
But true cataclysmic financial debacles tend to involve investment strategies and financial securities that everyone thought were boring. For example, triple-A rated bonds that turn out to be backed by financial junk, or bets that centuries-old relationships between two securities will always remain constant.
What else like this may be lurking out there? What is the next debacle lurking within some unlikely corner of the global financial system? We are likely going to find out soon.
The overarching theme at the moment is that the US Federal Reserve is tightening monetary policy remarkably aggressively to quell inflation. Other central banks are influential in their own countries, and in some cases internationally, and are also raising interest rates.
But none come close to the Fed in sheer global power. It is the US central bank’s interest rate hikes that have supercharged the dollar and led the greenback to swat aside most other major currencies, like sterling, the euro, the yen and the renminbi. It is the US central bank’s interest rate hikes that are starting to reveal myriad little cracks in the financial system.
The UK’s wounds are to a large extent self-inflicted, from longtime issues like the yawning current account and budget deficit, to recent “own goals” like last week’s “fiscal event”. But it was unquestionably more vulnerable because of the Fed — the entire world’s de facto central bank — ratcheting monetary policy tighter and tighter.
And the examples are multiplying. While the UK shenanigans have overshadowed everything this week, the Chinese currency has also weakened dramatically lately. On Wednesday, it fell past the 7.25 per dollar level for the first time since early 2008 — yet more evidence of how the shift in American monetary policy is rattling across global markets. Japan and South Korea have already intervened to prop up their currencies; more are likely to if things continue like this.
This is the equivalent of a financial earthquake emanating out of the US, with aftershocks galore, which is going to reveal exactly which investment houses built in the last decade are solid or unexpectedly shaky. Before long, more are likely to collapse.
Hopefully they will just be a few shacks, and inflationary pressures will soon moderate enough for central banks to back down before they bring down anything bigger like the UK defined benefit pension plans.
robin.wigglesworth@ft.com