What is happening to the UK economy?

When the new economic measures announced by Kwasi Kwarteng caused a sharp drop in British Treasuries, the UK finance minister declared that “the markets will react as they wish”.

Five days later, the Bank of England intervened to prevent chaotic falls in bond prices from hurting pension funds and threatening financial stability.

The slump that began with the package of energy subsidies and tax cuts announced by Kwarteng has threatened to spiral out of control as parts of Britain’s £1.7 trillion pension industry dominate the market. of long-term government bonds – struggled to cope with the unprecedented rise in bond yields.

The strategies that many pension packages use to protect retirees from inflationary and interest rate risks were failing to withstand the pressure.

On Wednesday, the turmoil in pension funds was fueling a downward spiral in bond prices, and the Bank of England suspended plans to sell the bonds it holds. Instead, it announced bond purchases worth up to £5bn a day for 13 days to restore order.

“What became clear on Monday was that we were in a very messy market, with levels of volatility that we haven’t seen in at least 35 years,” said Simon Pilcher, chief investment officer at Universities Superannuation Scheme’s, which manages £80 billion in retirement funds from the fund’s 500,000 beneficiaries.

It had been a “challenge” for the fund to navigate the market under prevailing conditions, he added. “The Bank of England has now intervened with dramatic effect. It was a justified and timely intervention.”

Bond prices immediately hit a rally, resulting in the biggest one-day drop in its yield in 20 years — from 5.06% (its highest mark in two decades) to 4.01%. In the days before the “mini-budget” was announced, yields remained around 3.8%.

Before Wednesday’s injection of relative calm, huge swings in bond prices were baffling analysts and investors. “The movements in long-term yields were nothing short of incredible; the Treasury bond market was in freefall,” said Daniela Russell, director of interest rate strategy at HSBC for the UK market.

What sparked the process was Kwarteng’s announcement of a “mini-budget” tax cut last week, which suddenly boosted the value of the government’s planned bond sales for this financial year by £70 billion.

International investors were reluctant to fund the account. The British Treasury bond market suffered its worst day since the early 1990s, and the pound fell to its lowest against the dollar since 1985. A further blow came over the weekend as Kwarteng played down the U.S. market to the promise of even bigger cuts in the future, reinforcing the wave of bond sales and dropping the pound to its lowest historical rate against the dollar earlier in the week.

Mortgage rates rose even more. But it was tensions in UK pension funds that forced the Bank of England to take the reins.

In the long run, cheaper bonds and higher yields are good for pension funds because they help them reap returns for retirees. But in the short term, rising yields meant that thousands of pension funds had to face urgent demands from investment managers for additional funds to fund the margin payments related to hedging strategies.

As yields began to rise, the hedged positions had to be bolstered with additional collateral. Pension plans embarked on a spree of liquid asset sales, including Treasury bonds, to fill these orders, kicking off a vicious cycle of bond sales. Industry professionals have clamored for help to prevent the bond market from derailing and undermining the pensions of millions of savers as pension plans have become compulsory sellers of assets.

Between £1 trillion and £1.5 trillion of liabilities held by retirement funds are covered by so-called “liability-linked investment hedging strategies” (LDI).

“Because yields rose in response to Friday’s announcement of tax cuts for the wealthy without any revenue compensation, pension funds that had LDI swaps were forced to post collateral to cover losses generated by the movement of the market,” said Jim Leaviss, director of public fixed income investments at M&G Investments. “This is purely a liquidity problem — pension funds are solvent,” he added, but the Bank of England “feared that this could become a systemic problem. The need for intervention by the Bank of England to mitigate government damage doesn’t make a good impression.”

The UK pensions regulator stated that it “welcomes the measures announced by the Bank of England to restore orderly conditions. risk and financing arrangements, and plan accordingly to protect the interests of the beneficiaries of the plans”.

The surprise measures announced by the central bank may have bought time for pension funds to top up their guarantee levels in a more orderly fashion, some analysts say.

The Bank of England’s move “offers a potential way out of the UK’s burgeoning financial crisis,” said Antoine Bouvet, a rates strategist at ING.

Bank of England Governor Andrew Bailey and his colleagues remain in a delicate position. A temporary intervention is unlikely to hold back bond yields for long unless the government changes tack on its tax-reduction plans, said Mike Riddell, portfolio manager at Allianz Global Investors.

But if investors learn that Wednesday’s measures are the start of a more lasting intervention in the bond market, they may begin to doubt the Bank of England’s commitment to aggressive action to tame inflation, which the chief economist of the institution, Huw Pill, signaled on Tuesday.

A longer period of bond-buying by the Bank of England would certainly help the market, but would likely mean a further decline for the pound.

“This is extraordinary,” Riddell said. “The Bank of England announced to the market yesterday that it would take a very hardline stance, and today it is back to buying bonds. Something that is initially seen as temporary can often become permanent. If that appears to be the case, the pound could be in trouble”.