The new British Prime Minister stepped into office at a difficult time. The British economy and households were dealing with high inflation and slow economic growth. Both of these are direct results of Brexit in 2020 followed by the Covid19 Pandemic, the Dovish policy by the Bank of England, and the ongoing Russia-Ukraine war and related sanctions.
Truss after being appointed rolled out a plan to reduce corporate tax cuts and to offer subsidies to combat high energy bills, by introducing a price cap limit on energy bills of households. The rationale behind this was that “Trickle-down Economics” will play its part.
It wouldn’t take an economist to tell that this is a recipe for disaster.
To understand this better, let’s learn some important concepts and terminologies going to be used.
Pension Funds rely on LDI (Liability Driven Investment) strategies. The main goal of LDIs is to ensure pension funds have enough money to pay what they owe to retirees. The payouts are expected to be 30-40 years in the future.
Before we proceed, the last 2 things to keep in mind are. Firstly, UK Pension Funds have more than £1 Trillion invested in them and secondly, Bond Yields and Bonds Prices are inversely proportional to each other. If the Yields go up, the prices come down, and vice versa.
The way LDIs work is, that the fund managers would buy long-dated govt securities. Like anything else in the world of finance, no investment plan goes through with hedging (securing the risk) your investments. Funds purchase Complex-Derivatives Products with the bonds to mitigate the risks associated with bond yield fluctuations. They use the already purchased bonds as collateral to purchase Derivative Products.
Now the actual story begins. Since the govt. announced that they are going to cut the corporate tax rate, which means less revenue, and provide more subsidies to people, which means more spending. They had to bridge this gap between revenue and expense. For it the govt. will raise money from the public by issuing more bonds in the market, more bonds in the market mean, more supply than demand which will push down the prices of bonds in the markets. Now we already know what happens when prices go down. The yields go up. Higher yields mean expensive money raising for the govt. and lower prices on bonds mean the Pension Funds that have pledged those bonds will now have to put more money on the table in to limit their losses on their “Derivatives Products”. Because no one in the plant has unlimited money in their banks, they started selling the Govt. Bonds to pay up for their “Margin Calls” (call from their insurers to pay for the loss on Derivatives Products).
The markets were in free fall because the Govt., the Bank of England, and British Pension Funds were selling Gilts (UK Govt. Bonds)
Govt was selling bonds to raise money to help offset its tax cuts and other stimulus efforts. The central bank was selling bonds to suck the liquidity out of circulation to tackle high inflation and Pension Funds were selling the bonds to get cash to cover the investment loans they had taken out. The UK also has something called the “Pension Protection Fund” for such scenarios but the “Margin Calls” were so huge that even the pension protection fund was unable to pay this without dumping assets.
Eventually, the BoE had to step in with emergency bond buyback measures worth £65 billion (initially) to stop this self-reinforcing spiral and widespread financial instability.
The final blow to her political downfall came from her Home Secretary Suella Braverman’s racist remarks that jeopardized the desperately needed India-UK Free Trade Agreement.
With the economy in the doldrums and no EU available to help, the Finance Minister & Home Secretary forcefully resigning, panic set in the financial system that not only did her administration has a poor understanding of the market but also that she has no grip over the political arena.
Truss lost the trust of the system and was tossed out of 10 Downing Street.
–BY ASHISH K NARWAL
