ALEX BRUMMER: The Bank of England ignored its own alert over LDIs

The cautionary note that explains the Bank of England’s extraordinary £65billion rescue in the bonds market appears on page 54 of its November 2018 Financial Stability Report.

It argues that it is ‘not clear’ whether pension funds and insurers pay sufficient attention to the liquidity risks involved in using liability driven investment (LDI) programmes intended to improve the returns from gilts.

The Bank committed to work with other enforcers – the Prudential Regulation Authority (an arm of the Bank) the Pensions Regulator and the Financial Conduct Authority – to monitor all the things which could go wrong, from a lack of cash to losses generated by non-bank leverage or credit.

Unfocused: By allowing the gap between the yield on UK gilts and US treasuries to widen, the Bank of England’s interest rate setting Monetary Policy Committee left an open goal

That all went well then!

Four years after the Bank’s sotto voce warning, the taxpayer has been required to rescue a market involving the life savings and pensions of 10m people. It should not have been difficult to see this coming.

City players BlackRock, Schroders, Legal & General et al invented a wonderful tool, using borrowed money, derivatives and other techniques, to improve the performance of gilt portfolios. 

Paradoxically, the objective was to strengthen the funding of private sector pensions, many of which were in deficit. It took off like a rocket with the markets tripling in a decade to £1.5trillion.

Lord (Simon) Wolfson, Britain’s most impressive retailer, says he was so concerned about the financial sector’s love affair with LDIs, having sat through many sales pitches, that he wrote to the Bank of England in 2017, suggesting action to address the risk.

As was the case in the years leading up to the financial crisis and in the Libor interest rate fixing scandal, the Bank’s ability to process intelligence and do something about it was wanting.

It was only with the prospect of insolvencies cascading through the financial system, affecting the whole pensions structure, that it went to the Treasury and launched a lifeboat, having first secured an indemnity.

The same Bank that has been oddly reluctant to dissolve EU regulation, because of fears that pension funds and insurers might invest in risky assets such as infrastructure, had a potential catastrophe under its nose.

The Bank rightly can point to some extraordinary conditions, with the pound under pressure and the long 30-year gilt plummeting in value.

Neither of these might have happened if the interest rate-setting Monetary Policy Committee (MPC) had been bolder at its September meeting.

Members may not have been fully appraised of the Chancellor Kwasi Kwarteng’s supply-side tilt, but they knew the Federal Reserve had raised interest rates by three-quarters of a percentage point.

The US central bank has moved decisively to crush an inflation rate partly caused by a monetary splurge. By allowing the gap between the yield on UK gilts and US treasuries to widen, the MPC left an open goal which was plundered by traders.

But no one should think the current bond tantrum is a uniquely British problem. As the FT reported this week, the much larger and more important $24trillion US bond market has recently been hit with the greatest turbulence since Covid-19. It had then required large-scale interventions from the Federal Reserve to prevent the whole financial system from blowing a gasket.

Andrew Bailey, the Governor of the Bank of England, played a part then (as now) by joining with other central banks, putting in place dollar swap arrangements designed to shore up confidence.

The bond market tantrums, and fire and brimstone from the Fed and other central banks are overdone in the view of veteran monetarist Patrick Minford.

Monetary expansion on both sides of the Atlantic has been reduced to zero and, as the global economy slows and falls into recession, inflation will dissipate as quickly as it began. Minford forecasts UK consumer prices falling to 5 per cent by next year – an arresting argument that runs against the current consensus from Wall Street and City brokers.

The herd instinct in the financial markets has undermined the LDI strategies for pension funds.

And sloppy, unfocused regulation by the Bank of England et al exposed retirement funds to petrifying risks.