UK mini-budget sparks gilt market mayhem

On 22 September 2022, Kwasi Kwarteng, then UK chancellor, announced a series of expansionary fiscal measures including some supply-side policies and tax cuts.¹ These represented one of the largest tax giveaways in the last forty years at an estimated GBP 45 billion per year. Markets reacted negatively to the budget, with the 30-year gilt yield spiking 120 basis points over three days, one of the largest yield increases ever seen in such a short space of time. However, it was fuelled by more than just market reaction to the so-called “mini-budget”. A technicality in liability-driven investment (LDI) strategies adopted by pension funds was a key driving force behind the long-dated gilt selloff.

Defined benefit pensions are required to ensure that their assets can generate enough cash to meet their liabilities (monthly pay-outs guaranteed to pensioners). LDI strategies use derivatives to help many defined benefit pension funds match assets and liabilities to reduce the risk of shortfall caused by market volatility. Long-dated gilts are often used as the underlying assets in these derivatives. According to the Investment Association, the UK pensions market had total assets of GBP 4.2 trillion in 2021.² Defined benefit pensions made up the highest proportion of this, with GBP 1.8 trillion in assets. LDI strategies accounted for around 38% of pension funds’ total assets, at GBP 1.6 trillion, equivalent to around two thirds of the UK’s GDP in 2021.

Pension funds have to post cash as collateral against their LDI derivatives in case their value declines. The amount of collateral required rises as the value of the underlying assets tracked by the derivatives falls. For example, estimates made in October 2019 suggest that a rise of 291 basis points in the long-dated gilt yield would have depleted all pension collateral in LDI schemes at that time.³ 

From 1 October 2019 to 22 September 2022, 30-year gilt yields rose 283 basis points (see Chart 1). In the three days following the mini-budget, the yield rose a further 120bps, implying pension funds had to raise cash to meet collateral calls. Many funds sold long-dated gilts to do this, which pushed yields up further, making hedging trades even more expensive and triggering a new round of collateral calls. The feedback loop of rising yields forcing LDI pension funds to sell gilts played a large part in the behaviour of the gilt market in the days following the mini-budget.

Chart 1. UK government 30-year bond yield (%)

Source: Refinitiv, The Pensions Regulator and EFGAM calculations. Data as at 16 October 2022.

To ensure proper market functioning, the BoE were forced to step in and purchase long-dated gilts. In a letter to MPs, Sir Jon Cunliffe, Deputy Governor for Financial Stability at the BoE, noted that without intervention, a number of LDI funds would have been left with negative net asset value and would have faced shortfalls in the collateral posted to banking counterparties. If these funds then defaulted, the feedback loop would have been amplified, causing a further selloff in gilts, and resulting in an “excessive and sudden tightening of financing conditions for the real economy”.⁴

The BoE had been planning to sell GBP 80 billion of gilts over 12-months beginning in September as part of its monetary policy operations but was forced to postpone this operation until October. It emphasised that purchases of long-dated gilts were not a monetary policy instrument and would act to absorb temporarily the excess selling of long-dated and index linked gilts associated with LDI strategies. This explains why the drop in bond yields as the BoE began purchasing gilts was temporary, with the central bank only purchasing GBP 19.26 billion of the allocated GBP 65 billion from 28 September 2022 to the end of the program on 14 October 2022 (see Chart 2). The aim was not to depress gilt yields, but to allow pension funds to meet liquidity needs through sales. This point was further emphasised by the launch of a Temporary Expanded Collateral Repo Facility (TECRF) through which banks would be able to help ease liquidity pressures facing their client LDI funds through liquidity insurance operations.⁵

Chart 2. BoE temporary purchases of gilts (GBP, billions)

Source: Bank of England and EFGAM calculations. Data as at 16 October 2022.

As the end of the temporary gilt purchase program approached, questions remained over whether the BoE would be forced to extend the program to prevent further financial instability. The only solution appeared to be a reversal to the mini-budget that sparked the ordeal. On 14 October, this was partially delivered as Prime Minister Liz Truss sacked Chancellor Kwasi Kwarteng and announced that corporation tax would rise from 19% to 25% in 2023, as originally planned before the mini-budget, raising GBP 18 billion in taxes. Kwarteng was replaced by former health secretary Jeremy Hunt who, on 17 October, cancelled the bulk of the planned tax cuts and announced that the Energy Price Guarantee would only last until April, being more targeted thereafter.6 Only a national insurance and stamp duty cut remained from the previously announced measures.

The saga over the last few weeks has raised more questions than answers. The ability of LDI funds to cause large selloffs in long-dated gilts highlighted the need for better regulation and has led to UK MPs probing the Pensions Regulator over its role in supervising pension plans.7 Despite Kwarteng’s sacking, many of the policies in the mini-budget were championed by Liz Truss in her leadership campaign and there is uncertainty about where the reversal of most of these policies leaves her politically. The BoE may also have its resolve tested regarding its planned quantitative tightening in October, as it will not want to cause further chaos in the gilt market. What is certain, is that further volatility lies ahead for UK politics and financial assets.

¹ See EFGAM Macro Flash Note, Sterling under pressure after UK Chancellor announcements (September 2022)
² http://go.pardot.com/e/931253/urvey202021-2220Chapter204-pdf/2dfzy/113623957?h=5jMWAIjbwJMY7guYw2LM6tm9Xhw6C_arEHTfb79Lh90
³ http://go.pardot.com/e/931253/rage-and-liquidity-survey-ashx/2dg12/113623957?h=5jMWAIjbwJMY7guYw2LM6tm9Xhw6C_arEHTfb79Lh90
⁴ http://go.pardot.com/e/931253/0136-documents-174584-default-/2dg15/113623957?h=5jMWAIjbwJMY7guYw2LM6tm9Xhw6C_arEHTfb79Lh90
⁵ http://go.pardot.com/e/931253/-to-include-index-linked-gilts/2dg18/113623957?h=5jMWAIjbwJMY7guYw2LM6tm9Xhw6C_arEHTfb79Lh90
⁶ http://go.pardot.com/e/931253/c9-1c45-464b-b7d1-c1c2d37311e6/2dg1c/113623957?h=5jMWAIjbwJMY7guYw2LM6tm9Xhw6C_arEHTfb79Lh90
⁷ http://go.pardot.com/e/931253/70-ee96-44d1-861d-a01e066b34a5/2dg1g/113623957?h=5jMWAIjbwJMY7guYw2LM6tm9Xhw6C_arEHTfb79Lh90