The financial system in England almost crashed this week.
On Wednesday, September 28th, 2022, the Bank of England launched an emergency intervention to restore order in the market for United Kingdom (UK) bonds. With 2022 already shaping up to be a difficult year for bonds around the world, central banks have increased interest rates to combat inflation — England is no exception.
The chart below shows the price of the UK’s 30-year bonds this year.
After reaching a high of 97.78 in March, prices seemed to have settled down around 60 earlier this month, representing a 38% drop.
Last week, the UK government announced a new round of tax cuts, which would require more borrowing. This sent UK bonds into a tailspin, dropping from 60 down to 42 — the low price on Tuesday, September 27th, which represented a 30% drop in a week.
The decrease in prices since March had grown to 57%. The Bank of England’s intervention of 1 billion pounds pushed prices back up to 53, an increase of 32% in a single day of trading.
Let’s take a step back and think about this for a moment. We’re talking about an economically developed country’s bonds moving in increments of 30%. But this isn’t Greece — it’s England. This is historic volatility.
Extreme volatility can be caused when investors who borrowed against their holdings need to sell those holdings as soon as possible to cover their losses. There is speculation that this is what is currently unfolding across the pond.
Pension funds responsible for paying retirees’ benefits have used leverage to increase their returns for years, which wasn’t a problem when interest rates were low and thought to remain that way. When you use leverage, your portfolio itself is the collateral, but when the value of that collateral falls, you need to add funds or sell positions.
The market is currently moving faster than funds can raise cash, meaning funds may need to sell other unrelated positions like stocks or corporate bonds to raise the necessary reserves. However, that dynamic introduces systematic risk to the entire global economy as one fund’s liquidation can push prices down enough to where it endangers another fund, and so on and so forth. It is a vicious cycle that becomes a race for the exits.
This led to Bank of England stepping in to try to put an end to that cycle — or at least install a short-term solution — with the bond-buying program continuing until mid-October. This policy shift is in stark contrast to the Bank’s actions earlier this year. Like the Federal Reserve in the United States, the Bank of England had been selling bonds from their balance sheet in an attempt to control inflation.
Speculation aside, whatever was happening was serious enough for the Bank of England to intervene, acting as the “lender of last resort” by providing short-term liquidity to a distressed market to ensure solvent entities didn’t unnecessarily go broke. Perhaps “God Save the Pension Funds” should be the new national anthem.
If you have any questions, please do not hesitate to contact your Impact Capital advisor.