Aditya Shah Profile picture
Oct 12, 2022 21 tweets 6 min read Read on X
UK's Leveraged pension funds are in trouble!

Bank of England says there is a severe risk to UK's financial stability!

UK now poses a material challenge to the world economy!

A detailed thread🧵on what is going on in the United Kingdom

Lets go👇

(1/21)
What is happening across the world?

Inflation rates are zooming across the world to some very uncomfortable levels!

This means for the first time after 2008, we are on an aggressive rate hike cycle.

(2/21)
United States:-

For far too long the US Fed called Inflation "Transitory"!

The Effect?
Now we see the steepest Interest rate hike cycle in the last 35 years!

(3/21)
United Kingdom:-

Bank of England is also in the middle of a steep interest rate hike.

This has meant a sharp rise in yields!

(4/21)
UK bond yields are back above 4%, to 2008 levels.

No wonder homeowners are worried given the almost doubling of house prices from 2009 lows (2nd chart)

(5/21)
Gas shortage fueling Electricity crisis adds to the problems:-

Gas-fired power stations account for more than 40% of UK electricity generation while gas is also responsible for heating the vast majority of homes.

(6/21)
This has meant energy costs have shot up by 10x in the UK.

Energy Inflation is at 40%.

(7/21)
So what is the problem?

Liz Truss promised tax cuts for the ultra-rich.

This would have meant the UK government would have borrowed more in the bond markets.

(8/21)
Effect?

As the market began to price in more borrowing:-

This led to the yields spiking by 100bps.
The bond markets were very very nervous.

Bonds started to lose value as yields spiked

(9/21)
UK Pension Funds:-

Pension Funds in the UK is a big industry.
They have assets topping about $4 Trillion.

In the last 15 years, pension funds turned to Liability Driven Investment (LDI) to manage their risk.

(10/21)
Fund managers calculate the duration of future obligations,hold fixed-income assets that have the same duration

Imagine u owe someone $200 a year for next 10 years
If u buy a bond that pays out $200 a year for 10 years,u won’t face any risk of not making your payments

(11/21)
In the quest to generate higher returns.

Pension funds started to leverage the assets!

Say you have £100 of assets and invested like this:

£95 in gilts,
£5 in stocks
Borrow another £100 and put that in gilts too

You’re hedged if rates go down as bond prices move up!

(12/21)
But what if the interest rates go up?

As the yields on Bonds started to move up.
Prices of bonds started to fall!

The assets of all pension funds start to lose value.
The leveraged positions start to hurt.

(13/21)
Long-term UK Gilt bonds have posted a total return of -52.3% since Dec 2021.

An entire decade of gains wiped out.

(14/21)
As bonds lose value,

Due to leverage

Lenders said:-
U used our money to buy assets,
The assets went down,
So give us some money back”

This is called a Margin call where more collateral /money must be given!

Leverage turned pension funds into toxic assets

(15/21)
Funds had to post more collateral immediately, which was impossible logistically.

Some funds lost their hedge and the bonds underlying their position were sold, making the problem even worse.

Hence, the central bank had to step in

(16/21)
So,

As the Bank of England was raising Interest rates.

It had to come and inject liquidity into the system i.e. monetary easing to protect the system.

This will just make the Inflation problem even bigger for the UK,

(17/21)
Good News-
UK govt has borrowed from the Market
There is good demand

Crazy news-
Interest rate=Inflation+1.5%
CPI Inflation in UK-9.9%

So the UK Govt is effectively paying 10.4%(will reset)

That is some crazy interest.

(18/21)
The Bank of England had to halt the bond-buying program by Oct 13.

But with pressure from pension funds, the program will last all thru October.

UK is clearly in crisis.

(19/21)
Conclusion:-

The leveraged Pension funds are a material risk for UK's economy.

The seeds for this were laid in the last 10 years.

As interest rates continue to move up.
Many other countries will start to face similar issues.

(20/21)
Bank of England faces the daunting task to save the British economy.

Mistimed tax cut announcements together with toxic pension funds and high energy costs will mean

UK will be in a recession in 2023.
The only hope is UK does avoid accidents.

(21/21)

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