UK fundamentals turn into technical

The UK’s mini budget has garnered much attention since it was announced in September. The primary impact on fixed income markets was the large sell off in Gilts as markets took offence to the sizeable package announced, particularly as it was essentially unfunded, and therefore reliant on future borrowing through Gilt issuance.  Some of this had already been priced in to Gilt markets, but some surprise measures along with the suggestion from Chancellor Kwasi Kwarteng that this was only the start of the tax cuts exacerbated the market reaction. Subsequently, the additional inflationary and Gilt supply pressures justified the initial move up in yields.

However, within a few trading sessions of the budget announcement, 10 year Gilts had widened by over 100bp whilst the 30 year sold off by almost 150bp – gigantic moves in a short amount of time. And this was on top of a 70bp move wider in both instruments already seen in early September in the run up to the budget, as well as the spike in government yields seen globally year to date. The reason for the sell off in Gilts transforming from just large, to very uncomfortable, was the technical of Liability Driven Investments (LDI).

The LDI strategy helps pension funds, largely through leverage to hedge long dated pension liabilities, allowing them to allocate some portion of cash to credit, equities and less liquid assets – thereby boosting returns. This has been done prudently and worked well for many years with the long term nature of a pension product – helping plans to be funded. However, matching liabilities to long term Gilts through these products means that if Gilts sell off, pension funds need to post more collateral to banks for the mark-to-market hit. 

This calendar year has broken many records and in doing so broken many financial models. The big move in Gilts this year resulted in funds selling assets, but to date this has been relatively orderly, with sufficient collateral for pension funds to post.  However, the ~140bps move in long dated Gilt yields, in just a few days, required even more margin calls, and the only way this was achievable was through selling liquid assets  – the most liquid of which being Gilts… therefore further pushing up yields and further increasing the requirement for collateral – the vicious cycle. The need for liquidity spread into credit markets and the nature of the situation sent markets into turmoil.  It was this volatility last Wednesday, that forced the Bank of England to step in by announcing that they would be buying long dated bonds.

As many market participants asked ‘Buying bonds? Aren’t they supposed to be selling?’, the Bank explained that they would be buying up to £65bn bonds over the next couple of weeks with a maturity of over 20 years and that this targeted short term measure was action from the FPC to ensure financial stability and so doesn’t fly in the face of the MPC’s overall monetary policy goals. The headline led to the 30 year Gilt rallying by ~140bp Gilt retracing its entire move since the mini budget, and the 10 year coming in by 50bp.  

They actually haven’t had to buy that much – to a certain extent it has been the ability to purchase rather than actual purchases that effected the retracement. With just over £2.5bn of bonds actually bought thus far, it seems the BOE has been able to establish a ceiling on long end Gilts, allowed the market to take a breather and in doing so helped to boost its credibility.  Yet again, when called upon, the power of the Central Bank helped to calm markets – and with very few bonds being bought. 

Yesterday, the UK Chancellor also announced he would be rolling back the tax cut for the highest income bracket and sources have implied that he will bring forward his medium-term fiscal budget, which will hopefully be the beginning of a more conciliatory tone by the Government and greater stability.

However, whilst Gilt markets have retraced the majority of its moves the credit market has yet to recover, though we expect this to happen with improved stability. Once again the current fragility of wider market sentiment was clear to see last week, and as potential volatility remains high we believe it is a necessity to keep ample liquidity to allow flexibility.