Year to date, in order to control rising inflation, the Bank of England has continued to increase interest rates, but has been relatively cautious in doing so, as it runs the risk of raising rates too quickly which could result in a sustained period of recession.
On Thursday 22 September 2022, the Bank announced it would be raising interest rates by 0.5% to 2.25% (the highest level since 2008) and in a further inflationary tackling move, it announced it would start selling c£80bn of UK government bonds (around 10% of those purchased historically via Quantitative Easing). The market reacted moderately to this news and bond yields rose. When the price of bonds fall, yields rise – and the expectation of more bonds coming to market meant bond prices fell and subsequently yields rose.
On Friday 23 September 2022, the new UK Chancellor, Kwasi Kwarteng, announced his emergency budget. The Government's spending plans will require significant additional borrowing (c£400bn over the next two years), as a result the UK Government will need to issue more debt than ever before to meet this need.
Over the last few days, it has become apparent that the two UK fiscal and monetary policy groups (the Government and Bank of England) have different and opposing objectives – as a result, UK gilts and Sterling have been negatively impacted as the global markets have struggled for clarity over how this will play out.
Ultimately markets dislike uncertainty, and this juxtaposition has caused volatility. What will happen to UK politics, the economy and financial sector remains unclear – more recent comments from the Chancellor which intimated that he was not focused on market moves have led global markets to act accordingly.
Market Reactions
Sterling fell nearly 4% against the US dollar on Friday 23 September and hit a record low on Monday morning. This would suggest that these moves are reactionary and are about market confidence and have little to do with traditional interest rate differentials.
Since the Chancellor’s announcement, yields on 10-year bonds have risen to around 4.5% (the highest level since 2008), increasing by around 3% since the start of the year.
Unusually the Internal Monetary Fund (IMF) has publicly raised its concerns stating: “It is important that fiscal policy does not work at cross purposes to monetary policy” and: “Given elevated inflation pressures in many countries, including the UK, we do not recommend large and untargeted fiscal packages at this juncture”.
Clearly, the Bank has a more difficult challenge to control inflation. On 28 September 2022, it announced it will again start buying government bonds to restore some stability and has backtracked on the plan to sell bonds it originally owned. The Bank now hopes to lower bond prices by stepping in as a buyer. Yields on 10-year bonds fell back around 0.5% after the Bank's intervention.
Impact
The quantum of such movements has been unheralded and the impact on pension schemes may be extreme.
In the light of rising yields, leveraged liability-driven investments (“LDI”) have come under pressure. With falling bond prices the leverage within these products has increased, in many cases to a level which has resulted in the managers requiring cash to recapitalise the funds and bring this level of leverage down. The quantum and frequency of these “capital calls” over 2022 has never been seen before, and it is important that trustees know how to deal with these issues.
On the flipside to this, many schemes will have found that their funding positions have improved (particularly those that have not fully hedged their interest rate and inflation risks).
Finally, given the huge fall observed in the price of government bonds, other assets held may in relative terms have fared better and as a result a pension scheme’s actual asset allocation may now be significantly different to its long-term target.
Conclusion
Given all that has happened over the last few days and the potential for funding levels to have improved, coupled with the actions that may be needed to address portfolio liquidity to manage ongoing LDI collateral calls, it may be the ideal time to contact your investment consultant to see what, if any, actions should be taken.