Is the Bank of England facing another storm? Op-Ed by Stuart Cole, macro economist at Equiti Capital

What triggered the UK gilt market sell-off and is the Bank of England (BoE) facing another storm?

– The dislocation in the UK gilt market was unprecedented.
– Was this reversal triggered by the Bank of England’s need to protect its own pension scheme?
– Is the Bank of England facing another storm?

UK gilt market sell-off unprecedented

Recent volatility in the UK gilt market has been unprecedented. With the UK Government’s planned tax cuts blamed for triggering this, the market was on course to see yields post their sharpest monthly rise since the late-1950s. Despite having already been warned that rising yields were proving problematic for the pension industry, the initial reaction from the Bank of England to this turbulence was to do nothing, stating on 26th September 2022 that it simply remained ready to raise interest rates as necessary to return inflation to its 2% target and would wait until November’s scheduled Monetary Policy Committee meeting before deciding if measures were needed to address the gilt market. This lack of response saw yields shoot higher and within 48 hours policy was reversed: an announcement was made cancelling the BoE’s planned quantitative tightening programme and instead notice was given of a temporary window of unlimited gilt buying, “to restore orderly market conditions”.

What was the reason for this reversal? Were the warnings the BoE had received from the pensions industry ignored, or did it simply fail to understand and anticipate the scale of the problem?
Were they even simply ignored; or dismissed?

Defined benefit schemes most at risk

The gilt sell-off seen following the Bank of England’s initial statement was very much triggered by a problem that has the UK pension fund industry at its heart, notably the ‘defined benefit’ (DB) pension schemes. DB schemes pay members a fixed income, normally a percentage of their final salary earned as employees. However, the crucial factor is that these payments are guaranteed regardless of the value of the underlying fund.

To hedge these liabilities, DB funds invest a proportion of their assets in long-dated gilts to ensure liabilities are met for decades going forward. These positions are themselves often then hedged via gilt instrument derivatives, managed by what are known as liability-driven investment funds (LDIFs). These limit the exposure of the DB funds to market volatility. But the crucial factor here is that these hedging instruments typically require the DB fund to post collateral to the LDIF when yields rise, receiving collateral back when yields fall. During episodes of market dislocation when yields can rise suddenly, DB funds can find themselves posting ever more collateral to the LDIFs as their positions become loss-making. In extreme cases they may be forced to sell assets – such as gilts – to raise sufficient collateral for this, an action that drives yields higher. Because of this structure, it was the DB funds that were most caught out by the sudden spike in yields and in danger of becoming insolvent.

DB funds are estimated to hold reserves to cover a 200 basis points rise in swap rates. This year alone, 30-yr gilt yields have risen by around 397 basis points to their peak on 28th September, with around 150 basis points of that rise seen in just the four days preceding. Even now, they remain around 280 basis points above levels seen at the start of the year.

Early warnings made to the Bank of England

The pension funds and LDIFs began warning the BoE in the week before the market meltdown that collateral calls were becoming increasingly expensive and could become unaffordable if yields continued to rise. The BoE’s response was to ignore these warnings. Possibly it decided this was an issue for the pension fund industry to address, not the central authorities. In an environment of rising interest rates, funds need to hold less money now to pay pensions in the future, strengthening their funding positions. It is also hard to argue that pension funds had not had sufficient time to address the impact of higher yields and ensure adequate collateral was in place, given yields had been steadily rising all year.

But whatever the Bank of England’s stance, given the warnings it had received that such planning had not taken place and action was needed, its apparent decision to ignore them now appears reckless. But what caused it to change policy so soon?

What made the BoE change its mind and is it facing another potential storm?

The BoE’s recent record in managing inflation and communicating policy suggests an aloofness from the market and this may explain why it initially saw no need to intervene in the gilt market: it simply failed to appreciate the problem pension funds were facing and the need for action, leading to an error of judgement.

But was the real reason for its policy reversal predicated on the fact that the funds it intervened to support were largely the DB pension funds? Estimated to be worth around £2 trillion, DB funds, once common, are now largely confined to the public sector, with three quarters of public employees thought to participate in them, including current and former staff in the BoE’s own pension scheme.

Was the BoE forced to intervene under pressure from its own pension fund trustees alongside those managing local and central government funds? If the market determines the BoE’s actions were dictated by the need to ‘look after its own,’ a whole new storm may yet be building.

Stuart Cole

Head Macro Economist for Equiti Capital

Stuart has over 25 years of experience in banking and FX.  His former roles include working at the Bank of England in the City of London as an economist in the International Divisions. In this role he prepared briefings for the IMF/World Bank/EBRD on UK policy towards Eastern Europe and the former Soviet Union, working closely with the Governor’s office and colleagues across Whitehall in HM Treasury, the FCO and the MoD. Stuart finished his career in the Bank of England as senior trader in the Bank’s FX division where he ran the cable book for the Bank. He later joined the Bank of Scotland to develop their central bank FX sales desk.  Following the takeover by Lloyds Bank he moved to their money market funding desk where he spent 4/5 years before joining Mizuho Bank as Head of their Financial Institutions Sales Desk. Stuart has a Master of Economics degree from Queen Mary College, University of London and a Bachelor of Economics from the University College of Wales, Aberystwyth, UK.

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