Liz and the LASH #NewsMarket

Is there anything more to write about the LDI crisis of autumn 2022? We thought not. Then this popped up:

Liz Truss’s tweet roughly quotes most of the opening sentence of the linked Wall Street Journal op-ed. The Journal’s Joseph C. Sternberg writes:

the outbreak of bond vigilantism that laid low Britain’s financial markets in autumn 2022 was an inside job.

It goes on to say that this judgement is

the belated conclusion of new research from the central bank at the heart of the fiasco

Can this be true? Was it the Bank [of England, for it is they] Wot Dun It?

A rough precis of the Truss “mini-Budget” gilt market crisis goes something like this:
— The largest package of unfunded tax cuts in half a century gets announced, and this spooks the bond market.
— With bond prices lower, leveraged pension funds engaging in so-called Liability Driven Investment (LDI) — running with lower-than-normal collateral levels — get margin-called on their positions.
— Lacking sufficient liquid capital to keep the trades alive, many are forced to unwind those positions. With large numbers of pension funds running forms of the same trade, and with UK defined benefit pension funds the largest investors in the gilt market, deleveraging into thin market drives gilts yields even higher, setting off new margin calls.
— This doom loop continues until the Bank of England steps in to prop up gilt prices, bailing out the financial system. Shortly afterwards, chancellor Kwasi Kwarteng and Truss herself both leave office in shame.

This precis will hardly be controversial to loyal Alphaville readers. This is pretty much exactly how we explained the crisis before the Bank had even had the chance to arrest it. Subsequently, it’s a version of events that has been consistently told in the Bank’s own series of autopsies, spelled out at length in speeches, working papers, and select committee testimonies.

But a key premise of the Journal piece is that this is “a revisionist history” — that until now, the Bank had stuck to the line that the bond market reaction had nothing much to do with LDI and everything to do with rational bond vigilantes reacting to Truss’s bold supply-side economic programme. Sternberg suggests that that is the story everyone thinks they know:

The prospect of massive deficit-funded fiscal giveaways by a government already laboring under enormous pandemic-era debts stirred bond vigilantes to action…

Before his big reveal:

The thing that melted down in response to this fiscal nonsurprise wasn’t “the market,” it was a badly constructed hedging strategy popular among defined-benefit pension funds.

This is weird. It wasn’t ever about pure vigilantism, and it’s bizarre that — while presenting the widely-accepted explanation as a revelation — the article still characterises the crisis as an “outbreak of bond vigilantism”.

“This history is worth getting right,” writes Sternberg. Quite.

What does this new(ish) Bank’s May Working Paper add then? It’s actually a pretty cool paper, introducing what its authors call ‘LASH risk’. Nothing to do with Downing Street lockdown parties, LASH stands for Liquidity After Solvency Hedging: the phenomenon of a pension fund’s solvency improving while its liquidity deteriorates as bond yields rise if it’s using derivatives in a Liability Driven Investment strategy. Readers may recall we wrote about this improving solvency/deteriorating liquidity dynamic while Kwarteng was still chancellor.

The paper uses transaction-level data collected from the FCA’s MiFID II database, the Bank of England’s Sterling Money Market database, DTCC and LSEG Regulatory Reporting Limited — covering bonds, gilt repo and swaps respectively. This provides the authors (Laura Alfaro, Saleem Bahaj, Robert Czech, Jonathon Hazell and Ioana Neamțu) an almost complete transaction-based record of gilt and gilt-related trading in the period.

The authors used this data to estimate how much of the sell-off during the period 23rd September to 14th October might be attributed to forced liquidations, leaving readers to infer that the remaining bond yield move might be attributed to more traditional bond vigilantism.

The scores on the doors over the 16-day ‘crisis period’, based on their analysis:

— Bond yield spike due to “bond vigilantes”, AKA the gilt market doing gilt market stuff = 37bps
— Bond yield spike attributed to pension funds getting margin called because of market losses from the bond spike due to Truss/Kwarteng unfunded tax cuts, AKA doom looping = 66bps

It’s a nice analysis. What it does not do is turn the established narrative on its head. In fact, it reinforces it.

The Journal’s piece has its context wrong, but of course that doesn’t necessarily mean its arguments are wrong.

Its justification for accusing the Bank of an “inside job” is actually one of monetary circumstances. Sternberg argues that the Bank bears responsibility for the existence of LDI because it held interest rates abnormally low for fifteen years, claiming the LASH paper:

…finds that roughly two-thirds of the calamitous September 2022 surge in gilt yields can be explained in one form or another by monetary policy.

That is simply not what the LASH paper says. To arrive at this view you would need an unshakeable prior that LDI-mageddon was an inevitable byproduct of monetary policy. This clearly defies international experience. And, as Dan Mikulskis guest-posted in his brief history of LDI here (back in October 2022) low bond yields – which are informed by monetary policy decisions – were part of LDI’s growth, but the history is more complicated.

Where does this leave Truss’s reputation? Unch.

Striking a match is not in and of itself stupid. But striking a match without checking whether you’re surrounded by kegs of gunpowder is. Similarly, announcing a growth plan involving deficit spending isn’t in itself irresponsible, but announcing it at a moment when collateral levels among leveraged gilt investors is wafer-thin means the likely market spook risks triggering a major run. And, as we wrote three months ahead of the mini-Budget, the gilt market was particularly vulnerable to an industry-wide margin call around the time Kwarteng stood at the dispatch box. As a result, we argued (back in November 2022) that ignorance of gilt market structure rather than fiscal profligacy was what really brought down Truss/Kwarteng.

One corollary of this, which bears emphasising, is that we still don’t really know how aware the Bank or civil servants at the Treasury were of the risk posed by LDI at the time. Tom Scholar, the most senior Treasury civil servant whose job it was to steer Kwarteng around such dangers, was sacked in his first meeting with the new chancellor. The OBR were denied access to the contents of the mini-Budget. Arguably, by being kept out of the loop they got lucky — but it’s reasonable as a result that the blame has landed almost exclusively with Truss and Kwarteng.

To deny any influence at all from monetary policy would also be daft (the combination of quantitative tightening and rate increases was a recipe for a steady ratcheting up of yields), but the Bank of England — unlike Truss and Kwarteng — can’t in good faith be accused of having taken anyone by surprise. They didn’t light a match. Truss did.

The LASH paper doesn’t change any of this. But the Bank’s new work is helpful to the world in general. Because despite the copious flow of analysis from FTAV and the Bank since the crisis began, a narrative has caught hold that making large unfunded tax cuts or spending commitments will necessarily wreck (rather than just spook) your bond market, and with it, your economy.

That is surely overblown. Context is everything.