Liz and LASH

Is there anything else to write about the fall 2022 LDI crisis? I thought not. Then this came up:

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

the outbreak of bond vigilantism that brought down UK financial markets in autumn 2022 was a domestic affair.

Ite goes on to say that this judgment is

the belated conclusion of new central bank research into the heart of the fiasco

Can it be true? Was the Bank (of England, for it is they) Wot Dun It?

A rough breakdown of the Truss gold market “mini-budget” crisis goes something like this:
— The biggest unfunded package of tax cuts in half a century is being announced, and it’s spooking the bond market.
— With bond prices lower, leveraged pension funds that engage in so-called liability-based investments (LDIs) — which operate with lower-than-normal levels of collateral — are demanding margin on their positions.
— Lacking sufficient liquid capital to keep trades alive, many are forced to exit these positions. With a large number of pension funds carrying out forms of the same trade, and with UK defined benefit pension funds the largest investors in the gilts market, de-leveraging the thin market drives gilt returns and higher, triggering new margin calls.
— This doom loop continues until the Bank of England steps in to prop up gilt prices, saving the financial system. Shortly afterwards, Chancellor Kwasi Kwarteng and Truss herself leave office in disgrace.

This precis will hardly be controversial for loyal Alphaville readers. That’s pretty much how I explained the crisis before the Bank even had a chance to arrest it. Subsequently, it is a version of events that has been consistently recounted in the Bank’s own series of post-mortems, described at length in speeches, working papers and select committee testimony.

But a key premise of the Journal article is that this is “revisionist history” – that until now, the Bank has stuck to the line that the bond market’s reaction had little to do with LDI and everything to do with judicial reaction rational of the bonds. to the bold economic program of the Truss offer. Sternberg suggests that that it’s the story everyone thinks they know:

The prospect of massive deficit-financed tax handouts from a government already laboring under enormous pandemic-era debt has prompted bond advocates to act…

Before his big reveal:

The thing that melted down in response to this fiscal non-surprise was not “the market,” but a poorly constructed hedging strategy popular among defined benefit pension funds.

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

“This history deserves to be corrected,” Sternberg writes. Enough.

What do what does this new Bank working paper add more then? It’s actually a pretty cool piece of work that presents what its authors call the “LASH risk.” Nothing to do with Downing Street housewarming 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 uses derivatives in a strategy of passive investments. Readers may recall that I wrote about this improving solvency/deteriorating liquidity dynamics 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 gives the authors (Laura Alfaro, Saleem Bahaj, Robert Czech, Jonathon Hazell and Ioana Neamțu) a nearly complete transaction-based record of gilt and gilt trading over the period.

The authors used this data to estimate how much of the sell-off from September 23 to October 14 could be attributed to forced liquidations, leaving readers to infer that the remaining movement in bond yields could be attributed to more traditional bond vigilantism.

Door scores during the 16-day “crunch period” based on their analysis:

— Rising bond yields due to “bond vigilantes”, AKA the bull market doing bull market stuff = 37 bps
— Increase in bond yields attributed to pension funds that received a margin due to market losses due to increase in bonds due to unfunded Truss/Kwarteng tax cuts, AKA doom looping = 66 bps

That’s a nice analysis. What it doesn’t do is turn the established narrative on its head. In fact, it strengthens it.

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

His justification for accusing the Bank of an “inside job” is actually one of monetary circumstances. Sternberg argues that the Bank is responsible for the existence of LDI because it kept interest rates abnormally low for fifteen years, arguing in the LASH paper:

… finds that about two-thirds of the disastrous September 2022 rise in gold yields can be explained in one form or another by monetary policy.

It’s just not what the LASH paper says. To reach this point, you will need an unshakable precedent that LDI-mageddon was a inevitable byproduct of monetary policy. This clearly defies international experience. And as Dan Mikulskis guest posted in his brief history of LDI here (in October 2022), low bond yields — which are informed by monetary policy decisions — were part of the rise in LDI, but the history is more complicated.

Where does this leave Truss’s reputation? uncle

Lighting a match is not in itself stupid. But starting a match without checking to see if you’re surrounded by kegs of gunpowder is. Similarly, announcing a growth plan that involves deficit spending is not in itself irresponsible, but announcing it at a time when collateral levels among leveraged investors are thin means that the market is likely to be at risk of a major crisis . And as I wrote three months before the mini-budget, the gold market was particularly vulnerable to an industry-wide margin call during Kwarteng’s time at the despatch box. Accordingly, I argued (in November 2022) that ignorance of the structure of the gilt market, rather than fiscal disarray, was what really brought down Truss/Kwarteng.

A corollary to this, which is worth pointing out, is that we still don’t really know how aware the Bank or Treasury civil servants were of the risk LDI posed at the time. Tom Scholar, the most senior Treasury civil servant whose job it was to steer Kwarteng around such dangers, was dismissed in his first meeting with the new chancellor. The OBR have been denied access to the contents of the mini-budget. Arguably, by keeping themselves out of the loop, they were lucky – but it stands to reason that the blame fell almost exclusively on Truss and Kwarteng.

To deny any influence from monetary policy would also be absurd (the combination of quantitative tightening and rising interest rates has been a recipe for consistently rising yields), but the Bank of England – unlike Truss and Kwarteng – cannot to be well. faith to be accused of taking someone by surprise. They didn’t light the match. Truss did it.

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

That’s definitely overkill. Context is everything.