A crack
Daily Thoughts 11 Apr 2025 (Free)
From Tuomas Malinen on Geopolitics and the Economy.
As expected, markets continued to crater yesterday after the historic rally on Wednesday. On Wednesday, the Dow Jones Industrial Average (DJIA) rose by 2962 points, making it the biggest point-wise rally in the history of the index. On Thursday, the DJIA nosedived by 1014 points, or 2.5%. Volatility has been massive, and we can expect it to continue.
This is because the situation in the financial markets remains precarious for the reasons I explained yesterday. I will now delve deeper into this by revisiting the gilt rout of September/October 2022, which threatened to bring down the pension funds of the U.K. and much of its financial system. The U.S. faces that risk now, still.
On the 28th of September, 2022, the Bank of England (BoE) was forced to step back into the British government bond, gilt, markets to prevent a collapse of the liability-driven investment funds, or LDIs. They were used by British pension funds to invest in assets that generate a steady (secure) flow of income to cover their liabilities, more precisely pension salaries. LDIs follow a so-called fixed income strategy, where the aim is to conserve capital and income by investing in assets that generate a steady (secure) cash flow. In Britain, final salary pension plans, which guaranteed a lifelong annual income upon retirement, owned many of them. To generate a steady flow of income, LDIs had acquired a large share of gilts, whose value was considered stable (also by the financial authorities).
However, the ultra-low yields of gilts forced the LDIs to add swaps to increase the yield to meet their income targets. With an interest rate swap, one can "sell" or exchange the fixed income stream (yield) from a long-term asset for a higher yield from a short-term asset. This procedure is similar to what banks do when they accept short-term deposits and provide long-term loans. With good collateral, like a bond from a trusted government, one can enter into several swap agreements to build leverage— that is, to attach several short-term contracts to the long-term asset to increase the income stream. Yet, unwinding such leveraged positions in a controlled manner takes time.
Then, within just 16 months, the BoE raised its Bank Rate, the rate commercial banks use to deposit funds to the central bank, from its historical low of 0.25% to 2.25%. This was one of the fastest interest rate hikes in the Bank's 330-year history, done to fight rising inflation. The BoE both raised the Bank Rate and sold its gilt holdings through its quantitative tightening program, causing the prices of bonds to fall.1 The rapid rate hike cycle led to a rapid decline in the value of gilts, which was very detrimental to the LDIs for two reasons. First, as the values of the bonds fell, they yielded less, which threatened the income stream they were obliged (by law) to sustain. Secondly, as the funds held gilts as collateral for their loans, their creditors (banks) started to require more collateral in margin calls (because the value of their current collateral, gilts, declined).
To this moment, the U.K.'s shortest-serving (49 days) Prime Minister Liz Truss added massive uncertainty by introducing a highly unbalanced budget. The budget included, e.g., tax cuts without balancing spending cuts. Investors were spooked, and yields of gilts spiked.
As a result, LDIs were forced to liquidate a considerable share of their long-term gilt positions, which totaled around two-thirds of the £1.5 trillion of assets they held. The fall in the prices of gilts was so rapid that many LDIs were at risk of falling into a negative net asset value, where their assets would have been worth less than their liabilities. Such an event would have led to a winding down of the funds, creating a 'fire sale' (where all assets are sold regardless of their price) of their assets and thus gilts.
This meant that there was a threat that many LDIs would dump their gilt holdings into the markets, creating an uncontrollable downward spiral in the prices (upward spiral on yields) of gilts, which many financial institutions, like banks, were holding as collateral. Such an event would have, most likely, disrupted the functioning of the British financial system, with the value of one of the most trusted assets (gilts) suddenly collapsing. This scenario threatened to lead to a deluge of margin calls from lenders and the collapse of the banking sector through the evaporation of the value of their main collateral. The BoE stepped in to buy the gilts, which raised their prices. This action either completely removed or notably eased the margin calls for LDIs. A financial crash was averted, narrowly.
This is the risk the U.S. faced on Wednesday before President Trump capitulated on the “pause”. To argue that this risk would not have influenced the president's decision would be tantamount to arguing that his Treasury Secretary is an imbecile. I am confident that he is not.
The problem, like I mentioned yesterday, is that nothing has essentially been fixed with the 90-day tariff pause, and bond investors are now nervous with the U.S. Treasuries in a way they were not before (for a very long time at least). A crack has appeared in the U.S. Treasury market. Let’s see how wide it grows during the coming weeks and months.
Have a great weekend!
Tuomas
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To remind you that the value of a bond is inversely related to its yield, implying that when prices fall, yields rise, and vice versa.