In 2018, the Bank of England investigated whether a big rise in interest rates would trigger a cascade of forced selling by bond investors, destabilizing the financial system. The answer was no, even if long-term rates rose a full percentage point in a week, which had never happened in records going back to 1990.
“The speed and scale of the moves in gilt yields was unprecedented,” the bank explained in a letter to Parliament. The refrain sounded familiar: the stock market crash of 1987, the near-failure of hedge fund Long-Term Capital Management in 1998, and the housing and mortgage crisis of 2007-09 were all precipitated by financial prices moving violently, by magnitudes outside historical experience.
This doesn’t mean they were chance events. In each case, the belief that such events were thought impossible caused investors to behave in ways that made those events inevitable. During the 2000s, the belief that home prices would never decline nationally drove a flood of money into houses, mortgages and related derivatives. The result was a massive, overleveraged bubble whose eventual demise sent home prices down and defaults up.
The British bond market debacle might be a sign of similar dynamics at work and another reason to expect structurally higher, more volatile real (inflation-adjusted) interest rates in coming years. Real 10-year gilt yields stood at 1.13% Wednesday, compared with minus 0.44% on Sept. 22, according to
Real yields in the U.S. have also shot up.
In the years after the global financial crisis, economists concluded that sluggish growth and inflation that persistently ran below central banks’ targets had become a permanent feature of the economic landscape, bringing structurally lower real interest rates. Investors naturally sought out strategies designed to profit from such an environment. Pension funds were especially eager, because lower rates made it more difficult to pay promised benefits.
One such strategy was “liability-driven investment,” in which the pension fund enters into a derivatives-based contract to pay a floating interest rate and receive a fixed interest rate tied to government bond yields. To amplify returns, many funds used leverage—borrowing with gilts as collateral—to expand their positions up to sevenfold.
The strategy made money, provided long-term interest rates didn’t go up, and even more money if rates actually went down, as they did for much of the decade, said
an independent pensions analyst and a critic of the strategy. “Lower for longer became something of a mantra. There were very few people that believed we were likely to see rates rise sharply, as late as last Christmas,” he said.
Regulators implicitly encouraged this strategy. In its November, 2018 financial stability report, the Bank of England included a lengthy analysis of leverage at pension funds, hedge funds, insurance companies and other “nonbanks.” It was mostly concerned that margin calls could lead to forced sales of assets that the market couldn’t absorb without big price moves. It concluded any such selling would be small “as a proportion of the total demand on market liquidity,” even if rates rose a full percentage point in a single day or week, which “has never been experienced in 10-year sterling swap rates looking back to 1990. Even over a month, it would be a 1-in-1,000 event,” plenty of time for a relatively smooth adjustment, BOE wrote.
In part thanks to those benign assumptions, the notional value of LDIs soared from £400 billion in 2011 to £1.6 trillion, equivalent to $1.7 trillion, last year, a staggering sum. This indirectly put downward pressure on long-term interest rates, making investors’ expectation of low rates partly self-fulfilling. But as high inflation sent rates higher this year, the opposite happened. LDI positions began to lose money. The jump in yields following the tax-cut announcement triggered widespread margin calls and forced liquidation of positions. A strategy that had once amplified downward pressure on rates is now doing the opposite.
SHARE YOUR THOUGHTS
What do you think will happen with bond yields? Join the conversation below.
There are almost certainly many other strategies designed for a low-rate world that are now switching into reverse. Before 1998, stock and bond prices were positively correlated: They rose and fell together. That was because inflation was the main driver of economic cycles. When it rose, the Fed tightened, which was bad for both stocks and bonds (whose prices move in the opposite direction to yields). But after 1998, inflation became low and stable, and the Fed mostly cut rates, sending bond prices up, in response to economic calamities that pounded the stock market.
Because bonds were now negatively correlated to stocks, they made a portfolio less risky and thus acquired value as a hedge. In a 2019 paper,
of the hedge fund D.E. Shaw & Co. estimated the shift from positive to negative correlation doubled how much of a typical portfolio would be allocated to bonds, contributing to a “massive repricing of fixed-income assets:”
Investors were now willing to accept much lower yields on bonds relative to cash. But with inflation roaring back this year, correlations have turned positive again and bonds are losing their hedge value. If sustained, this should lead to lower bond allocations and higher yields.
As investors exit strategies designed to exploit low real rates, they subtract an important source of demand for bonds. They thus compound other factors pushing real rates higher, including more volatile inflation, central bank bond sales and larger government debts. Whether that will offset the downward pressure from lower economic growth is unclear. But it is one more reason the benign financial conditions that prevailed before the pandemic are likely over.
Write to Greg Ip at [email protected]
Copyright ©2022 Dow Jones & Company, Inc. All Rights Reserved. 87990cbe856818d5eddac44c7b1cdeb8