In an emergency response to the spiking yields of U.K. government bonds and their impact on U.K. pension fund solvency, the Bank of England has announced that it will suspend the planned sale of gilts next week, as well as temporarily conduct —through October 14—an emergency £65 billion ($69 billion) purchase of long-dated government bonds in an effort to restore orderly conditions to the credit market. The move comes as pension funds are losing large amounts of capital, as they liquidate gilts to meet collateral calls.
The announcement marks a departure from the “quantitative tightening” program the Bank of England had begun to try to lessen its impact on interest rates. After the latest move was announced by the Bank of England, the 10- and 30-year gilt yields dropped by more than 30 basis points.
Over the past two decades, pension plans in the U.K. have become huge investors in liability-driven investment strategies, which match pension funds’ liability. In total, there are £1.5 trillion of assets held by U.K. pensions in LDI-hedged trades. Usually, U.K.-based defined benefit pension funds invest more than half of their assets in bonds, to match future liabilities.
To avoid being exposed to market volatility, the funds hedge their positioning through strategies using gilt derivatives. When yields go up too far, too fast, the plans need to provide collateral to their derivatives counterparties.
Since the beginning of this week, U.K. pension funds have been hit with at least £100 million ($107 million) of margin calls, according to the publication Risk. Pension funds may have to liquidate other assets to raise enough cash to meet the collateral calls. Furthermore, the movement in the pound and gilts have large consequences for pension funds that often invest in government bonds and debt securities. The rise in gilt yields over the past year and a half has been good news for underfunded pension funds, because the present value of liabilities falls when yields rise.
While the equity markets in Britain have been largely unaffected by the move in the currency, British treasury bonds were walloped in response to Chancellor of the Exchequer Kwasi Kwarteng’s mini-budget on September 23. Gilt yields spiked, with the 2-year gilt jumping up 75 basis points in the past week, while the 5-year and 10-year rose 100 basis points and the 30-year gilt rose 125 basis points, marking the sharpest monthly rise in gilt yields since 1957, according to a Reuters report.
The Bank of England’s emergency move follows the pound’s plummet to an all-time low against the U.S. dollar, which came in response to the budget’s announcement. This continues an extended run of dollar strength that has seen the pound sterling’s value crater 20% since the beginning of the year.
Kwarteng, a member of the Conservative Party, assumed the office earlier this month after a whirlwind few weeks in Britain’s political scene that witnessed the passing of Queen Elizabeth II, the longest reigning monarch in British history, and the introduction of Prime Minister Liz Truss after the resignation of former Prime Minister Boris Johnson.
The new budget features heavy tax cuts and a large dose of deficit financing in an effort to drive economic growth. The announced plan includes reducing the basic rate of income tax to 19% from 20%, cutting the top bracket of income taxes to 40% from 45%, raising the threshold cap for stamp duty on home purchases, ending a planned tax hike on beer, cider, wine and spirits and maintaining business taxes at 19%, scrapping a previously proposed rate of 25%. Kwarteng’s plan, which he followed by promising there would be “more to come,” is the biggest package of tax cuts and borrowing increases in Britain in more than 50 years.
The total cost of the permanent tax cuts announced by the chancellor are estimated to be £45 billion ($48.1 billion) by 2027, which Kwarteng said in a statement would “turn the vicious cycle of stagnation into a virtuous cycle of growth.” According to the Treasury, government borrowing will increase by £72 billion ($77 billion) due to the new budget. Currently, the U.K. has the second-lowest debt-to-GDP ratio in the G7 group of countries.
In addition to political turnover, the British economy faces stubbornly high inflation. The August year-over-year inflation print hit a 40-year high for the British economy, with a read of 9.87%.
To combat this inflation, the Bank of England has been aggressively raising rates in recent months. Surpassing the Federal Reserve, the Bank of England has raised seven times in the past year, with the effective rate of interest on borrowing for a two-year and five-year period reaching 4.5%, the highest levels since August 2008.
Though the depreciation of currency value and the rise in gilts may seem like a contained issue to Britain, currency moves can have a ripple effect in worldwide markets. A strong dollar can be a headwind for a majority of U.S. companies, as it makes exporters’ products less competitive and hurts multinationals that need to convert their foreign profits back into U.S. dollars.
Overall, 29% of S&P 500 companies’ revenues come from overseas, according to Goldman Sachs. Technology companies are most exposed, with 59% of their sales stemming from foreign markets.
Though companies can use currency hedging operations to avert some risks created by a strong dollar, its meteoric rise since the beginning of the year—which has seen the dollar up 25% against the Japanese yen, 15% against the euro and 12.5% against the Chinese renminbi—makes it more difficult for companies to respond and hedge appropriately.