On September 23, 2022, the new Chancellor, Kwasi Kwarteng, delivered a'mini budget' in which he introduced 'The Growth Plan,' which will be the centerpiece of the new government's economic policies. This mini-budget was issued against the backdrop of rising inflation and a looming recession in the United Kingdom. The tax adjustments proposed, along with recent promises of assistance for homes and businesses in meeting their energy bills, constitute a substantial 'fiscal event’ in our opinion.
In addition to the £60 billion energy price guarantee given to households by new Prime Minister Liz Truss over the next six months, the Chancellor spent another £60 billion to reduce energy bills for businesses, as well as £45 billion in corporate, payroll, and income tax cuts aimed squarely at the wealthy. Overall, these tax cuts and expenditure increases outnumber those adopted during the epidemic, putting the government debt on an unsustainable path.
A short-term boost to demand from greater spending and tax cuts has damaged trust in UK assets, necessitating a major increase in borrowing at a time when inflation is flirting with double digits. Fundamental concerns have been expressed regarding medium-term inflation pressures and the expected increased degree of interest rate hikes that the Bank of England (BoE) would need to manage inflation and inflation expectations in the longer run. However, the technical picture has become increasingly difficult as the market anticipates significant additional issuance to fund the additional spending and tax cuts announced, and the Bank of England prepares to begin the process of selling a portion of the gilts accumulated over successive rounds of asset purchases over the last decade or so (so-called quantitative tightening).
While higher yields are ultimately beneficial to pension schemes because they increase the rate at which liabilities are discounted, schemes with interest rate hedging placed through an LDI solution (pension schemes typically pay the floating-leg of an interest rate swap and receive fixed interest payments to hedge against a decline in rates and yields that would coincide with an increase in liabilities) have been required to find cash to meet collateral calls at increasing short nascent yields.
Following the release of the Government's mini-budget on September 22, real and nominal rates jumped dramatically throughout the curve, with 10-year nominal yields climbing 0.6% p.a. in two days to 4.5% p.a., and real yields rising from 0% p.a. to 1.1% by the close of business on September 27. Longer-dated nominal and real yields showed larger rises. After the Bank of England delayed gilt sales and announced the resumption of long-term bond purchases on September 28, market liquidity improved and rates dropped down, albeit they remain significantly higher quarter-to-date. This has added to the year-to-date large gains in yields as major central banks have hiked rates in a bid to reign in excessive inflation. Selling liquid bond and credit assets to fulfil collateral calls has led to credit spread widening, which we note is not restricted to the UK market.
The Bank of England's time-limited action has increased liquidity and decreased rates, offering some reprieve from more urgent collateral requests. However, the Bank of England is unwilling to provide liquidity beyond this limited window. We also anticipate that LDI managers will strive to implement more conservative procedures for leverage management in the future to account for a more volatile gilt market environment.
As a result, we believe clients should continue to monitor collateral adequacy and reposition portfolios to ensure they have a strong collateral position and enough liquidity to fulfil agreed-upon minimum criteria.