Lehman 2.0 Has The Fed Cornered: Equities Are At Risk (SP500)

Equities rallied midweek after a violent selloff triggered by hotter-than-expected inflation data in August, and increasing hawkishness from the Fed on reining in rising price pressures at all costs. The respite came after the Bank of England sided with a sharp pivot from its current policy tightening trajectory, calling instead for a buyback on long-dated UK Gilts (or UK sovereign bonds) “on whatever scale necessary” to prevent yields from surging uncontrollably and risk “wider economic damage”.

However, the relief was short-lived, as market declines resumed shortly in response to recurring reminders from Fed officials about their support for more aggressive monetary policy tightening to prevent inflation from becoming entrenched. Key benchmarks including the S&P 500 and Nasdaq 100 are dipping below or close to the previous mid-June lows, falling sharply towards levels last seen in November 2020.

The following analysis will dive into the context driving the Bank of England’s recent policy pivot towards quantitative easing, as tightening measures implemented by central banks across major economies gain momentum in the name of capping inflation, and gauge the related implications on U.S. equities in the near term.

What is Happening in the UK?

In response to surging inflation worldwide over the past year, major central banks have sought aggressive monetary policy tightening measures that include rapid interest rate hikes, which have sent sovereign bond yields – including the U.S. Treasury and UK Gilt – towards record levels. In the latest development, long-dated 30-year UK Gilt yields surged rapidly beyond 5% for the first time in two decades earlier this week, with U.S. Treasuries tracing a similar trajectory as yields on the benchmark 10-year notes surged beyond 4% on Wednesday for the first time in more than 10 years.

Recall the economics – bond yields measure the spread between the bond’s price and the bond’s interest payments. When there is a selloff in credits/bonds, prices come down due to the flood of supply in the market. And when prices come down, the spread between the bond’s price and its interest widens, resulting in higher yield. In other words, bond price and yield move in reverse – when there is a violent selloff, prices come down and yields surge.

So why did yields surge at such a rapid pace earlier this week? In addition to expectations for further rate hikes within the foreseeable future to counter inflationary pressures, the UK government’s recent proposal for the “largest tax cuts since the early 1970s” under new Prime Minister Liz Truss’ leadership worsened jitters across the market. The proposed package, which also includes subsidies for household energy bills, is expected to cost at least £150 billion ($169 billion), which will primarily come out of additional sovereign bond issuances:

The package of subsidies and tax cuts-which will be largely funded by borrowing-will cost more than £150 billion, equivalent to $169 billion, over the next couple of years, analysts say. The government said it would borrow an additional £72.4 billion to fund the package in the short term. However, the overall borrowing in the coming five years could be closer to £300 billion, said Azad Zangana, senior European economist at Schroders.

Source: The Wall Street Journal

Circling back to basic economics, more debt supply means further lowering of prices and higher yields. The long-dated 30-year UK Gilt yields surged beyond 5% earlier this week while the pound plunged toward record low levels after last Friday’s tax break proposal, with U.S. Treasury yields headed the same direction, drawing the Bank of England to intervene as part of efforts to stem the “furious selloff” that risks more economic damage.

And immediately after the Bank of England stepped in to arrest the selloff in UK Gilts with the announcement of buybacks on long-dated UK Gilts – less supply, means higher prices, lower yields – the notes’ 30-year yield diminished at a record pace to under 4% overnight. The surge in 10-year Treasury yields also stabilized under 3.8% as the bond-market selloff slowed, which also drove a brief relief rally in U.S. equities on Wednesday.

What is Incentivizing the Bank of England to Step In?

While the Bank of England has cited its intervention as a mean to “calm markets and prevent the financial contagion from causing wider economic damage”, market professionals spanning fund managers and strategists suggest that there is likely a bigger problem at hand. The rapid rise in UK bond yields was effectively putting the region’s pension funds at risk, given their participation in liability-driven investments, or LDIs:

The [Bank of England] stressed that it was not seeking to lower long-term government borrowing costs. Instead it wanted to buy time to prevent a vicious circle in which pension funds have to sell gilts immediately to meet demands for cash from their creditors. That process had put pension funds at risk of insolvency, because the mass sell-offs pushed down further the price of gilts held by funds as assets, requiring them to stump up even more cash. “At some point this morning I was worried this was the beginning of the end,” said a senior London-based banker, adding that at one point on Wednesday morning there were no buyers of long-dated UK gilts. “It was not quite a Lehman moment. But it got close.” …

“If there was no intervention today, gilt yields could have gone up to 7-8 per cent from 4.5 per cent this morning and in that situation around 90 per cent of UK pension funds would have run out of collateral,” said Kerrin Rosenberg, Cardano Investment chief executive. “They would have been wiped out.”

Source: Bloomberg

What are LDIs?

LDIs are largely favoured by pension funds to “match long-term liabilities they have to retirees with less capital than they would by owning regular long-dated government bonds”. Essentially, pension funds – which promise retirees a certain return upon their respective retirements – leverage LDIs, which are investments into a combination of derivatives (e.g., interest rate swaps), to generate the “same” level of return needed to satisfy their obligation to retirees as if they had invested in long-dated government bonds with guaranteed returns, but without the same extent of upfront investment. The difference in assets pledged to LDIs and actual long-dated government bonds are then allocated to other “higher growth assets like stocks or real estate”:

LDIs aim to help pensions close the gap between what they owe retirees and the money they have at hand by enabling them to invest less in hedging interest rate moves and more in higher growth assets like stocks or real estate. The pension funds invest money with an LDI manager. The LDI enters into trades that try to match a pension fund’s liabilities through a combination of bonds and derivatives such as interest rate swaps and repo trades.

Source: The Wall Street Journal

Now, the issue is that rapidly rising interest rates are putting this seemingly sound strategy at risk. The value of LDIs decrease when interest rates rise and yields surge, which then requires pension funds to raise “more collateral to back the investments” – recall that the essence of LDIs is that, for example, when pension funds put $1 of asset on the line they get $2 of exposure, but if your $1 on the line is now worth less, you have got to pay up on the difference to maintain the exposure ratio. As a result, pension funds in the UK have been scrambling to liquidate their positions in the “higher growth assets like stocks, corporate bonds or real estate” to cover margin calls on their LDIs. But by rapidly selling off the higher growth real assets, pension plans are essentially driving asset prices lower at the same time – and again, lower bond prices mean higher yields, and higher yields mean more collateral needed to maintain the LDIs, thus feeding into a vicious “death spiral”.

To better put into perspective the risk that this strategy exposes the UK’s already vulnerable economy to have the Bank of England not stepped in, we turn to the ballooning size of LDIs over the past 10 years:

Over the past decade, LDI has become a core investment strategy for many pension schemes. Pensions and others had invested £1.6 trillion in LDIs by 2021, up from £400 billion in 2011. A 2019 survey of 137 big UK pension schemes found 45% had increased their use of leverage in the past five years. the maximum leverage allowed by the pensions ranged up to 7x.

Source: The Wall Street Journal

What Does This Mean for the U.S. Economy?

LDIs are not only favoured by pension funds in the UK but also widely embraced by pension funds in other major economies – including the U.S., though at a lesser extent. Specifically, the popularity of LDIs surged in response to a regulatory change in 2006 that required pension funds to measure their contractual liabilities to retirees “using long-term corporate bond rates” (i.e., at present value). This had inadvertently incentivized the pension funds to incorporate LDIs as a hedge against the risk that “falling rates and rising inflation will increase their future obligations”.

As the U.S. economy unravelled this year amid aggressive rate hikes, surging inflation, and looming recession risks, the country’s corporate pension plans – similar to those in the UK – are also facing margin calls. The portfolio of pension funds, worth more than $1.8 trillion in the U.S., is reported to have “posted tens of millions of dollars in collateral over the course of this year as bond prices fell”.

And with more aggressive rate hikes on the Fed’s agenda in the near term until there is concrete evidence that the peak of inflation is well behind us, trillions of dollars’ worth of Americans’ retirement plans are at risk, adding further complexity to the market turmoil ahead.

What Does This Mean for Equities?

Under the current situation, there are really two immediate scenarios for how it will play out:

1. Continued capitulation – This would be the status quo. The Federal Reserve is expected to remain committed to their hawkish monetary policy tightening agenda to hopefully bring inflation down meaningfully and towards its 2% target. This means elevated Treasury yields will be sustained in the near term as borrowing costs surge, growth gets stifled, while price pressures remain high, resulting in further economic deterioration. And with soaring interest rates, LDIs are at risk, requiring pension funds to post more collateral, which could potentially lead to further liquidation of equity and credit investments, driving their prices lower and fuelling a vicious cycle of more collateral and price declines – the ultimate showdown.
2. Fed pivot – This would imitate the Bank of England’s current pivot, a temporary measure that has yet to prove its effectiveness in stemming a potentially larger downward economic spiral with the added complexity of unravelling LDIs and pension funds. However, if the Fed were to slow its pace of rate hikes and balance sheet runoff, it risks leaving inflation entrenched which would be similarly detrimental to the U.S. economy, though supply-driven price pressures are showing early signs of easing.

Either way, the global economic outlook remains struck in an increasingly opaque cloud of uncertainty. Volatility remains the near-term theme. While it may seem that the macro outlook is gaining some clarity after the Fed put its foot down on maintaining an aggressive tightening trajectory to tame inflation, the latest development regarding pension funds and LDIs – which have “largely gone unremarked” – introduces yet another layer of complexity to the dire market climate as if the flurry of unexpected events this year spanning protracted COVID restrictions and related disruptions, supply chain constraints, and impacts from the Russia-Ukraine war and ensuing sanctions were not enough to choke valuations across the board.