An analysis of the Bank of England governor’s statement – was he talking to the global markets or just to the Pension funds? – part 1

In another blog I have reported Andrew Bailey the governor of the Bank of England stating:

“We will be out by the end of this week. We think the rebalancing must be done ” he said.“My message to the funds involved and all the firms involved in managing those funds is: you’ve got three days left now. You’ve got to get this done.”

But was he talking to the global markets or just to the pension funds that they are trying to bail out by buying back their bonds? I will give an analysis of his statement in a piece divided into three parts.

What is the whole problem with the UK the pension funds and the bailout? What effects did Bailey’s statement have on world markets stock markets bonds markets the dollar and all of that?

Does the U.S.A. have the same similar problems as the UK pension problems and can these problems in the UK bond market seize up the whole world financial markets as a lot of people are starting to think?

Pension funds know that they must pay out a certain amount of money in one year five years or ten years based on the liabilities of people who are retiring. To do so they must take their pension fund and invest it in such a way that they have enough money to meet those liabilities when they become due. The problem is that most of them are actually underfunded based on their current returns. They are aware that they are underfunded but they may project that they will earn a percentage per year for the next 20 years so they are technically funded. But in reality they are not making these kinds of returns.

But with bonds paying almost nothing for many years they are attempting to play catch-up and they are doing so by doing riskier and riskier things such as using a lot of leverage with some pensions leveraging up to seven times their actual money. And the problem with falling interest rates over the years is that lower interest rates mean they need more money today to pay for those future liabilities.

Consider this: if you have $1000 to pay off in a year and your annual rate of return is zero percent you will need $1000 dollars today to pay for that $1000 dollar in a year. However if you needed to pay $1000 dollars in a year and could make a 100% return in one year you would only need $500 today.

So if the pension fund needs to pay out $1000 in 20 years but the return on their investments is 10% per year how much would they need now to pay out $1000 in 20 years? If they earned 10% they would only require $148. What happens if their earnings are only 5%? They would now require $376 and what if they only make 1%? They would require $819. As interest rates fall and their yearly return falls they will need more money today to cover these liabilities in the future.

As a result many of these pensions began purchasing products known as “Liability Driven Investments” or “IDIS” sold by firms such as Blackrock and others. It’s similar to those target retirement funds where you tell them you’re going to retire in 25 years and they rebalance your account until you need it. Except that these funds can leverage themselves up to four times. Leverage raises your risk significantly and these pension funds are supposed to invest in low-risk assets such as UK government bonds.

Consider the following scenario: you normally take 30 minutes to get to work but you get stuck in traffic and it now takes you another 20 minutes. This reflects the current low-interest rate environment. So once out of the traffic you drive faster to compensate for the time lost in traffic putting you at risk of a crash. This is what is happening to the pension funds in the United Kingdom.

The government’s proposal to eliminate the top 45% tax rate at a time when they are trying to fight inflation and the Bank of England is doing quantitative tightening by selling bonds sparked this crisis which they have now reversed course to bail out these pensions. As a result of the tax proposal long-term bonds were sold off and interest rates rose.

This became a problem for UK pensions because they had swaps that swapped the interest on long-term bonds for the interest payments on shorter-term bonds. As longer-term bond yields rolled the pensions had to pay out more money to the swap issuer while the bond price fell. They had to put up more collateral because it was leveraged. So how are they going to pay for this margin call? They must sell other assets which could include stocks or government bonds. And as they sell off government bonds to meet margin calls the price falls and interest rates rise exacerbating their pain because they face larger margin calls. It’s like a death spiral.

So the Bank of England has reversed its quantitative tightening policy of selling bonds and is now bailing out pensions by purchasing up to $65 billion in bonds until Friday October 14th.

So when the governor of the Bank of England made the market-spooking remark the IMF was also lowering global growth forecasts.

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