Odd Lots - Toby Nangle on What We Just Learned From Gilt Market Madness

Episode Date: October 6, 2022

UK financial assets just experienced once-in-a-generation type moves in the wake of the government's mini-budget announcement. Not only did both gilts and the pound sell off dramatically, they rebounded just as dramatically after intervention from the Bank of England. What does it all mean? And how did pension accounting contribute to the massive volatility? On this episode of the Odd Lots podcast, we spoke with Toby Nangle, an economics and markets commentator, who spent several years running asset allocation at Columbia Threadneedle. He explains why we saw such a dramatic move and what the whole thing taught us about market structure.See omnystudio.com/listener for privacy information.

The news doesn't stop on the weekends. Context changes constantly. And now Bloomberg is the place to stay on top of it all. Hi, I'm David Gurra. Join us every Saturday and Sunday for the new Bloomberg this weekend. I'm Christina Rafini. We'll bring you the latest headlines, in-depth analysis, and big interviews. All the stories that hit home on your days off.

And I'm Lisa Mateo. Watch and listen to Bloomberg this weekend for thoughtful, enlightening conversations about business, lifestyle, people, and culture. On Saturday mornings, we put the past week's events into context, examining what happened in the markets and the world. That on Sundays we speak with journalists, columnists, and key political figures to prepare you for the week ahead. Join us as soon as you wake up and bring us with you wherever your weekend plans take you. Watch us on Bloomberg Television.

Listen on Bloomberg Radio, stream the show live on the Bloomberg business app, or listen to the podcast. That's Bloomberg this weekend. Saturdays and Sundays starting at 7 a.m. Eastern. Make us part of your weekend routine on Bloomberg Television, radio. and wherever you get your podcasts. Oh, and welcome to another episode of the Oblots podcast. I'm Tracy Allaway.

And I'm Joe Wisenthall. Joe, we need to talk about the UK. Yeah, we definitely do. You know, the last couple weeks, of course, have been consumed by the volatility and the pound and the guilt market. And I think it's actually good that we waited a few days. Maybe it would have been fun to like do one right away. But there's so much confusion that I actually think for learning something, it kind of helps to have waited a few days. That's my excuse.

Well, I'm going to start this conversation with a massive caveat, which is we are recording this on October 3rd. Things can change in the couple days that it takes us to get this out. And already things have changed quite a bit. So, you know, the week before we recorded this, we saw massive movements in the UK market. So we saw five-year gilts at like 4.7%, which was the highest since 2008. We saw an even bigger move in longer-dated gilts. I think the 20-year was at almost 5%. It's now back below 4%.

The pound reached a record low against the dollar. All of this was after the UK unveiled a mini budget that featured a bunch of tax cuts that were expected to balloon the public deficit at a time of inflationary pressure in the UK, Joe. I'm just going to make that point. But even then, you know, in the one week since all of that happened, we now have the UK Prime Minister of Liz Truss coming out and basically doing a U-turn on one big component of the mini budget, which was the tax cuts. And so we're seeing some relief in the market, but there's still this big question over what exactly just happened. Right. And so it really, I mean, the story

kind of started on September 23rd when those tax cuts were announced. It really started accelerating in the middle of the following week. The Bank of England was forced to essentially enter the market. And when you have these big moves in government bond, there's always this debate and you've written about it for years. In other contexts, it's like, how much is, quote, fundamental and how much is technical? How much does it have to do with market structure versus some sort of like meaningful signal about the path of expected inflation or the Bank of England's policy rates? And at times, there is a deviation. And it seemed at least at one point last week that there was a pretty big deviation between something like fundamental versus the sort of like technical driven market

that may have been causing a run of sort in at least one corner of the market. Right. So we are going to be getting into this technicals versus fundamentals question with really the perfect guest. The perfect guest. We're going to be speaking to Toby Nangle. He is an economic and markets commentator who worked in asset management for 25 years, formerly the head of global asset allocation for Columbia Threadneedle, also a previous Oddlots guest and someone who is quite philosophical at times over money and what markets are telling us. But also apparently can get technical too. Combine the philosophy with the technical. Which is a rare combination. Yes. So I'm looking forward to this conversation. Toby, thank you so much for coming on all lots. Thanks for having

me. So maybe a basic question to start off with, but how remarkable were the events of the previous week or so in your mind? Oh my goodness. Yeah. I mean, for the guilt market, there's nothing like that in my career and I was looking back using Bank of England data and you can't really find something like it for the part, well, since 1978 on the daily data that they have there. To have the short gilt market completely reprice the Bank of England rate path in the way it did and then also the long end kind of go from this big bear flattening into this huge bear steepening as you had liquidation trades and a run dynamic unfold with the Bank of England and having to intervene to start buying bonds when it's true.

trying to do QT. I mean, there's nothing like it. It's really an extraordinary episode. We need to talk to Richard Silla, you know, history of interest rates going back to like 2000 years. That was one of our first episodes. To find something comparable, it sounds like, it really was wild. And all someone has to do is look up a chart of like 10 year guilt or anything. You just see these multi-standard deviation moves that are supposed to happen like one every 100,000 years happening a few days. But before we even get to like what was really driving last week, I'm curious like in the weeks prior to this, it appears we've been seeing this deterioration of market liquidity, pretty big sell-off in government bond markets around the world,

strain starting to emerge with so much tightening from central banks. Like going prior to September 23rd, the day of the mini budget, what were conditions like? What was trading like in your view in government bonds. So, I mean, you're quite right. It's in an environment of rising bond yields around the world, driven really by the Fed, but also what's going on in the ECB and what's anticipated to happen in the UK. From what I understand, I mean, liquidity hasn't been, you know, amazingly good,

but there was nothing that I heard that was pointing to, you know, a complete collapse or anything like that. I can see Joe is setting up his argument for later. No, it turned out everything was fine. I have no argument anymore. Okay. Okay. So the Bank of England stepped in, which provoked a whole bunch of commentary about things like fiscal dominance. And the accepted explanation or narrative for why they stepped in now is because something was going on with pensions. And basically we were getting this sort of like self-fulfilling cycle of yields going up, pensions having to sell stuff off and then yields go up more. Can you walk us through exactly what the issue was there? Yeah, sure. So in the UK market, asset management market, the biggest segment by far is something's called liability-driven investment, or LDI. And to understand that, you need to kind of rewind probably about 25 years. There were these moves in the wake of this guy called Robert Maxwell, who's probably best known today in the North American audience for being Jolene Maxwell's father.

Oh, dear. Yeah. So he ran a media empire, the mirror group, and before he fell off his yacht and drowned near the Canary. Ireland, he'd fraudulently taken hundreds of millions of pounds from the Mirror Group Pension scheme, leaving those pensioners basically, you know, without a pension. So it's a huge scandal, cause of bankruptcy of that media empire and a big bailout of the mirror pension scheme. So then you kind of bring in this minimum funding requirement for UK pensions. At the same time, accountancy standards are changing.

You have this thing called FRS-17, which goes on FRS-102 in the UK or International Accounting standard IAS 19 for global, which kind of says, do you know what? A pension is sort of like a deferred piece of payment for an employee. It's like a long series of zeros, right? I mean, as in long zero coupon bonds. So we should probably value them like long zero. So we get a bunch of actuaries to work these things out and then discount them back using bond deals. So suddenly, you know, you had financial statements that were full of fluctuating pension fund mismatches of assets and liabilities. And at the same time, you had this regulatory pressure to say, you know, you probably don't want to have your pension fund hugely underfunded.

You can invest in anything you want, but if you've got a big funding deficit, then you've got to present a recovery plan, which might mean over that period you can pay no dividends, you can't do M&A, we might say you can't change people on your board, all these kind of things that firms don't want to do. And so firms go, well, how do we deal with this? And number one, they kind of shut down their pension schemes for new entrants. And number two, they look to better match the assets and the liabilities. their liabilities looking bond-like. So this is kind of like the deep history of it. Now,

what's this got to do with derivatives and last week, right? Yeah. Well, pretty much almost every pension fund couldn't quite afford to match their assets and the liabilities. So what they do instead is they have a growth portfolio, which is kind of low volatility. This should be cash over time. And then they've got a matching portfolio, and that might be long-dated guilt. Now, the liabilities look a lot like long-dated guilt, insofar as a long-dated, about 25-year duration instruments, right? Right. But they might only have like 25% in the matching assets and 75% in low volatility growth assets. So what they do is they put an overlay over the rest of it using swaps or doing kind of repo on that matching portfolio to generate leverage.

And the leverage varies a lot, but like, you know, it would be up to like sort of four, four point two times for the largest schemes. You can get the news whenever you want it with Bloomberg News Now. I'm Amy Morris. And I'm Karen Moscow here to tell you about our new on-demand news report, delivered right to your podcast feed. Bloomberg News Now is a short five-minute audio report on the day's top stories. Episodes are published throughout the day with the latest information and data to keep you informed. Yes, there are other products like this from a variety of news organizations.

But they usually rerun their radio newscast. throughout the day. That's not what we do. We create customized episodes that can only be heard on Bloomberg News Now. And we don't wait an hour to publish breaking news. When news breaks, we'll have an episode up in your podcast feed within minutes. So you're always getting the latest stories and developments. Get the reporting and the context from Bloomberg's 3,000 journalists and analysts we're all over the world. Listen to the latest from Bloomberg News Now on Apple, Spotify, or anywhere you listen. Walk us through the mechanics, actually. Yeah.

What happens, setting aside the craziness of last week, what happens mathematically for the pensions when rates go up, as they have been this year? Okay, okay, yeah. So if you have a pension fund, it's called assets, which will be financial securities and other stuff, and it will be have liabilities. So let's say at the beginning of the year, you're a pension fund, and your assets are 100, and your liabilities are 100. Right.

Long-dated bond yields rise, you know, a lot. Let's say there rise 100 basis points in your liability. You've got duration 25. So now your liabilities are only 75 in present value terms. Now your assets, they would have maybe fallen a bit because growth hasn't been fantastic. But also on the liability side, those guilts have been worth less. And then the swap overlay is worth less. So what mathematically will have been happening during the year is that pretty much every month,

they'll probably be rebalancing so that they get back to being fully hedged. and they don't have any kind of crazy stuff going on. So just to be clear, the value of the assets has, in a rising rate period, the value of the assets has fallen. But if it's orderly, it's okay because by the accounting standards, the total value of the obligations has fallen as well. Absolutely. I mean, we think of pensions as investors, but what they're really trying to do is they're trying to solve their problem. And their problem is that they don't want to leave their beneficiaries with an unsecure outcome, right? Right.

So that means that they don't go around going, oh, how do I juice a little bit more out of this or that? They're thinking, how can I get my funding ratio into a better place? And if they got their funding ratio in a great place, then they don't really care what yield are doing. So this is like, you know, it's fine. LDI works fine in low-yield environment. It works fine in a high-yield environment. It doesn't work fine if you move from a low-yielding environment to a high-yielding environment. super, super quickly, and maybe we should have a look at the mechanics of that.

Well, so this was going to be my next question. What exactly happens in that scenario when you get a sharp move or yields move very quickly? And when you have that type of volatility, is it a problem because of the optics related to the pension fund? You know, no one wants to say that they're underfunded and then have a bunch of press written about that or be restricted in what they can do going forward. or is it a problem in terms of technical stuff that they have to do, like stump up more collateral to cover some of those swaps that you just described? Okay, it's the second one, but also importantly, in a thing that I haven't said yet far, it's quite important,

is that they tend to actually be underhedged. So rising yields actually help their funding ratios. So that kind of hypothetical scheme at the beginning of year, which had 100 assets and 100 liabilities, now has 75 liabilities, it might actually have like 80 assets rather than 75. And so it's actually in a much, much better funding ratio than it was before. There's this big windful gain that's come through, even though the assets are fallen, right? It's winning, if you like.

So from the optics, the optics are good, but then there can be the mechanics. And like really annoyingly, there are kind of three different ways, at least which they kind of implement. But let's just focus on, let's focus on like two max. Okay. So one of which is that they implement directly. So they have that matching pool of assets like GILTS and then the growth pool with like a swap overlay or repo on the matching assets. Now they've effectively got geared long data GILTS. And when guilt prices fall a lot very quickly, that's going to make the collateral worth less.

Also, the P&L on the derivative overlay will be sharply into negative. So you're going to have to put up more collateral and the collateral's worth less. and so that's going to be a problem. There's going to be liquidity situation there. It's not a funding solvency or funding ratio issue, but there's a liquidity problem there. So that's one route. The second route is something which I think a lot more schemes have had problems with, which is they're not big enough to have ISDAs in place with their counterparties and then having

swaps going in place. So what they do is they go to an asset manager that has a solutions arm and the asset manager says, you know, I'll tell you what, we'll take. your 100 pounds and we'll put 75 pounds in this growth portfolio and we'll put 25 pounds in this pooled leverage matching fund, which has all the leverage within it and there's nothing outside that, along with like 100 other pension schemes. Right. Now, if you as a pension scheme with your 100 pounds, you've got liquidity to make sure that you can put in more collateral if you need to because, you know, your funding ratio is improving. This is great. And so you're all set up fantastically.

But maybe some of those other schemes, they don't have liquidity. Maybe they're invested in private credit or infrastructure or other long-term types of things, which don't have great liquidity. Now, if the asset manager says, okay, we've got a recapitalization event, so you need to transfer more funds in, then they're unable to do anything about it. And so their hedge just starts to fall away, even if the whole structure within those pool funds is maintained. But the asset manager sometimes might even kind of go, do you know what? like, you know, we're not going to get recapitalization for most of these. We might just decide to de-lever them ourselves. And that's what you saw. I think one of the announcements over the weekend come out from a large asset manager, I just have like a million questions, but I'll start. And just

to sort of recap what you're saying, you know, sometimes in markets, sometimes I'm skeptical of it, but sometimes in markets, people make a distinction between a liquidity crisis and a solvency crisis. And so just to be clear, what you described is sort of, you're, you're It seems like a fairly clear example of what should be categorized as a liquidity crisis. Because in some cases, maybe the move in rates improved the overall solvency and created a gap between the value of the assets today and the obligations. But the mechanics of it and there were several different avenues, this really sounds like liquidity was the key issue here. That's absolutely right, Joe. And moreover, the only route falling.

liquidity for some of these was actually selling long-dated guilt or unwinding long-dated swaps, which kind of then boils down to, like, you know, the Bank of England when they intervened, they weren't doing it to bail out pension schemes. It might actually, I think, I think actually genuinely, it will have disadvantaged large numbers of pension schemes materially by their actions. Tracy, you know, I'm thinking, it feels like this is actually a common theme this year, And I'm thinking like some of the commodity volatility that we saw earlier in the year where you have these commodity producers that are actually benefiting from a sort of solvency basis by the fact that commodities were surging. But due to the funding costs of their hedges were at risk of going bankrupt despite favorable commodity. Right. And also just the pro cyclicality of margin calls, which is something we also saw in the commodities market.

Okay. So on that note, Toby, you just mentioned the BEOE coming. in what exactly did they do, first off, and is it QE or not, and why does it matter? And then secondly, what impact has that had on the pension fund? So you mentioned that it might actually have been negative for them in terms of a funding perspective, but it would have broken the liquidity margin called doom loop that you just described. Yeah, that's right. So the Bank of England, they saw that this doom loop was in place, and that you don't know where that's going to lead, right, that could undermine the entire financial system.

So they intervened with an announcement that they would do daily auctions of up to $5 billion each in long-dated securities. And they did their first auction, and I think it was like just over a billion was offered. But the announcement just collapsed long yields by 100 basis points. I mean, a huge move. I mean, if you've got 25-year duration in this stuff, that's a 25% price jump just on the announcement, which is just phenomenal. So that's what they're technically doing.

Is that QE? I think that technically you could talk about it as balance sheet enlargement, but I think it can only be understood as a lender of last resort, or rather market maker of last resort function that it's stepping in to do. It's protecting the financial system. It's not trying to reverse QT in any way. And I think actually it was they executed it, and the results are probably way beyond their expectations.

And then the second question was about, like, what was the impact on pension funds? Well, some of these pension funds were being cleared out of their hedges, whether through their choice or through their manager's choices, up when long-dated yields were above 5%. And so if you think of that fund that's feeling really great because its assets are fallen by 20% year-to-date, but its liabilities are down 25% year-to-date. And you have like the assets and liabilities going up and down in this rollercoaster together. Well, the assets just fell out when a game undledged. And the liabilities rose back up hugely after the Bank of England intervention. And so that windfall gain, which might have come from rising yields, because they're a little bit underhedged.

I don't know the impact like system-systemically, and I don't think anyone knows the impact systematically yet as to what the hits been for them. Hopefully it's small. I think in a macroeconomic terms it will be small, but it'll be hugely painful for a number of schemes. So I'm thinking back to in the U.S., in, and I guess elsewhere, but in the U.S. in spring 2020, the onset of the pandemic. And there was a similar situation with leveraged hedge funds that armed cash treasuries versus futures, and the Fed had to step in and restore calm to the market. And then, you know, the people have talked about the idea of like a standing repo facility, such that at any given time you can just get liquidity for what within any given system should be the safest, most. liquid asset. Would something like that in the UK had it, is there anything equivalent to that in place? Or would something like that be useful such that the central bank doesn't have to make

ad hoc decisions about when to step in, but allow players to at any time get central bank liquidity for their guilt? So I don't think that there was, I mean, I could be wrong. So I'm going to caveat that. But I don't think that there was a problem about getting liquidity for your guilt. I don't think that people were wondering, you know, how do I, how do I get finance for this? It's more that, owing to the structure of their leverage, the value of their guilt had reduced such that, you know, they just didn't have enough collateral. I mean, consultants will be talk about, you know, I was speaking to a CIO of an investment consultant for a piece I read in July, setting up this whole, you know, concern about LDI. And he told me, listen, one of my clients

had 1.5 billion pounds of excess collateral when guilt yields were down at the lows during the pandemic. They've now got zero and they need to get another billion pound collateral call to come through so they're selling things. That was in June, right? That was the effect of what had happened through then. So you had, let's say that 25, which was guilt's,

you might have only needed 10 to put in that pot for collateral. And then 15 could have been excess collateral. Then, you know, as yields rise, so your excess collateral shrinks, down and then you need to replenish it. You need to rebalance. And these things can happen. You know, it can cause a little bit of strains on the system, but they can happen over months, but they can't happen over 48 hours. So speaking of collateral calls, which is basically a synonym for forced deleveraging, I know we talked about the sort of doom loop of, you know, yields going up. And so

pension funds have to sell more guilt. And then that forces yields to go up more, particularly at the long end, but we've also seen some chatter about other assets being sold to satisfy these margin requirements. What have you seen there? I've seen talk of credit, you know, specifically some ETFs, given that they're more liquid than underlying cash bonds, but also I've seen people talk about the impact going as far as the Australian mortgage market last week. Yeah, yeah, I saw Australian RMBS. I'll go on bid in private credit. Yeah, absolutely. It's for an offer. I'd say that the vast majority of large pension schemes, which are in the UK market large, I mean, LDI liability-driven investment covers around, I mean, covered the last count, which will be

smaller now, about one and a half trillion pounds, but that would be like out of, you know, close to two trillion pounds worth of defined benefit pensions. So these are the kind of magnities of numbers. Now, the vast majority of them will have come through this and feel, wow, our strategy survived. You know, we didn't get into force deal leveraging. This is fantastic. And they'll feel really great about that and I think that's good. But then they'll look at their asset allocation and they just go, whose asset allocation is this?

This doesn't look like my asset allocation because it was all pulled so out of kilter by the changes that have occurred. Not in the market values of the additional things, but rather the bond portion is shifted

around. The portion allocated to illiquids will be much higher than they'd probably had in their policy. And so there'll be this process of how do you get back to where you thought you were. And that's going to be kind of the order of business for the next few months, I think. I'm Francine Lacqua, an award-winning journalist. And I've got a new podcast, leaders with Francine Lacqua from Bloomberg Podcasts. I've interviewed everyone from Heads of State to fashion icons about the news of the moment.

But I've always been curious, who are these people as leaders? I don't think there's one right way to be a leader. Make decisions. A poor decision is always better than no decision. Listen to new episodes every other Monday. Follow leaders with Francine Lacroix wherever you get your podcasts. Can we back up? We mentioned your role, head of asset allocation at Columbia Threadn Needle.

Can you just talk a little bit more for the, you know, Tracy and I have known you for years. We've had you on the podcast. Smart guy on details. Smart guy on vague philosophical. questions about the definition of money, but maybe for people who are listening to you for the first time. Can you describe what you did, but also like, what is the sort of normal state of the guilt market? Who is trading them? Who owns them? And like what is sort of like the ecosystem of guilt holders and traders? What does that look like in normal time from your perspective?

So, yeah, I used to be global head of asset allocation at Columbia Threadneedle, which is a large investment firm. My team managed what about $160 billion. across teams in four time zones. The UK, frankly, is a fairly small part of that global area. But I had quite a lot of contact because a fund I managed. I mean, it served as a growth fund for pension funds that were looking at liability-driven investment, that sort of thing. So I had conversations with pension fund trustees

and consultants over the past 10, 15 years to understand the kind of aims and ambitions that they have and how they're trying to implement these things. And in terms of the gilt market more generally, the guilt market is, I mean, the UK defined benefit pension system is just very large compared to the amount of fixed income out there. I wrote a piece a few years ago, which I haven't revisited, which was looking at the amount of duration in sterling denominated instruments and comparing it to the duration of defined benefit pension schemes. Like if they all wanted to just allocate to bonds, could they? No, is the answer. There simply isn't enough UK, or at least there wasn't enough UK duration for them to do that. They would have to take basis risk. They would have to go out and think of other strategies, use derivatives, in order to try to get towards that kind of locked funding ratio.

I know we've been focused on pension funds for the most part, but in terms of those overlay strategies used to pump up leverage and therefore pump up returns, I mean, this was one of the suspicions about, some of the big bond funds for the past 10 years or so. I'm thinking of one in particular, selling a lot of volatility, you know, taking on a lot of duration risk and things like that. How endemic are these overlay strategies to asset management in general? I don't think that they are particularly endemic. I mean, beyond the largest portion of the UK asset management industry, which is a liability-driven investment side. But I think it's really, really important. because I realized you said at the beginning, you can get really geeky, that's okay, and I have done, because I'm part of your audience.

I listen to your podcast. I love it. And I think lots of super geeky people do. No offense to the rest of the audience. Geeks unite. But one of the things which I'm seeing in the mainstream, well, all across the mainstream press in the UK, is that leverage has been used to juice returns, to pump up returns. And that's not really what's.

going on here. What's really going on here is that there isn't enough UK fixed income duration and it doesn't seem necessarily unreasonable to think about a recovery strategy for UK pension scheme which uses synthetic duration to help you get there. What's been, I think, the lesson that will be taken away from here is that you need to have way larger cushions in place, sort of basis points to exhaustion, if you like, on your derivative platform in order to know with confidence you're going to be able to implement it properly, or you're going to have to have a much more liquid portfolio, which flies in the face of everything the government's been trying to do over the past few years to try and incentivize pension schemes to invest in infrastructure or property or, you know, venture capital

or all the sort of things that might help the country's growth profile. That's kind of like going to reverse now. I'm going to up the geek stakes now. Talk to us why there isn't enough supply of duration, because this is something that you hear in the U.S. as well, although, you know, a lot of the commentary there is about the central bank having sucked duration out of the market by purchasing MBS and other bonds. So, yeah, I mean, I've had this conversation about, like, why isn't there more duration in the UK market for, I mean, with various degrees of success, me trying to find the answer

for the past 25 years. I've spoken to, you know, past heads of the management office, UK governments, you know, different corporate treasurer. And where I've sort of got to on this is that actually, yeah, I would agree with the UK government that the UK government issues way longer than any other government. So the term structure of guilt is just hugely longer than any other G7 government in the world. Or in fact, I think any government in the world. And that's partly trying to satisfy that thirst for duration at the same time as balance a question which I didn't answer. Sorry, earlier, Tracy, when you said, well, who else is in the market for guilt?

So the shorter part, it's insurance funds, and longer part is all pension funds. The middle part is fairly vacant, really. So, yeah, the UK government already skews there in terms of corporate bonds. The corporate bond market in the UK is just really tiny. There isn't a huge amount of bond borrowing by UK companies. And I was kind of thinking, well, why? I mean, they're sort of doing this through having an unfunded pension scheme. And then it sort of struck me, well, maybe they've decided to do that.

there long-dated corporate borrowing through an unfunded pension scheme because the fees that go to the pension protection fund, which is our version of the PBGC, might actually be kind of lower than the aggregated, you know, the spread that you might pay. This is what I mean by Toby being both technical and philosophical at the same time. I like that. You know, it sounds like if there's a shortage of duration, then the government should enact a budget that increases guilt issuance by $45 billion. Weren't they just trying to solve a basic problem there?

But in all seriousness, on that point, I mean, there's kind of a troll, but also not really. Like, what is it, what was it about that announcement, you think? Yeah. That was so, like, this is what I'm still trying to wrap my head around. So triggering for the market. Right. And why I was like trying to, you know, I was asking about what were liquidity conditions in the days run up to it.

What was it about the announcement that caused such violence in the market? So, I mean, I was watching the announcement with a bunch of fellow geeks in a WhatsApp group. And we were looking at it and going, oh, my God, oh, wow, as he was sort of announcing these things. If you'd have asked me before, you know, if I'd have been that guy who's pulled into number 11 saying, so here's what we're going to do. I'd go, oh, wow, that's really, that's a bit of a shocker. If I was asked, like, what do you think the market's going to do? I wouldn't have said what it did.

Yeah, right. You know, and so, I mean, I think that you can explain what happened by two things. And this is kind of like, you know, it was partly the substance. I think that's definitely part of it. But it was also the style. So, you know, I mean, the new prime minister, Liz Tras and her chancellor, Quasi Qua Tuan came to power and the queen immediately died. And so nothing happened at all.

But they wanted to do stuff before Parliament sort of went into recess. Now, they're pretty iconoclastic in their style. During the whole leadership campaign, the Prime Minister put the Bank of England mandate into play. On the first day in the role, Quasi Qatang sacked Tom Scholar, who was the most senior and respected official in the Treasury. From their perspective, he'd be proud of the establishment. Quasi Qantasanang announces that it will be a fiscal event and it wouldn't be a budget because, you know, the OBR, the Office of Budget Responsibility, our version of the CBO. It has to look at budgets. It has to kind of put forecasts out.

And it's like, you know, he didn't want his homework marked by them. So all of these sort of stylistic things come through. And then you make a sort of a big sort of shocking announcement, which is way bigger than anyone was expecting. And the gill market seemed to have a bit of a meltdown straight away as the Bank of England was already hiking rates. And as you said at the start of the episode, rates around the world were already rising. And then over the weekend, so Friday, the 23rd, that was the biggest move in yields in 35 years. A huge move. Amazing.

And then, so over the weekend, quasi-Quartang's interviewed, and he doubles down. He's like, oh, we've got new unfunded tax cuts to add to this. And he's, you know, he's jocular about it. So, so Monday, you have a bigger move than you had on Friday. You know, the even bigger move in 35 years. The style is really important. You know, there's this kind of feel to markets, which I think you, I don't think it's like putting a slide rule and saying, you know, you do this measure, you get this number of basis points rise, the style is so important as well.

And that's why I think that today in coming out and doing a major U-turn after everyone saying they weren't going to do it. I mean, the Prime Minister was on national TV yesterday saying we're absolutely not going to U-turn. This is absolutely what we're going to do. And then they're in the middle of their annual party conference right now to come out in Utah. I mean, that's a big kind of like, okay, the style's over.

You know, we're changing now. This was going to be my next question, actually. You know, if it's more about the style and, you know, it really seems like there is a lack of a cohesive plan at this point. You can argue that maybe, you know, some aspects of it makes sense. And I know Joe has been doing his share of this on Twitter. I didn't say it made sense. But like after the U-turn, we have seen bond yields start to come down. We've seen Sterling start to recover.

Should that be the right interpretation of the market that the problem is solved now? It seems like if it's a problem of style and the UK government not really being sure what it's doing here, then that kind of U-turn doesn't necessarily bode well. I think the big important U-turn is on style, but there is also a substance return. For your listeners who are not in the UK realm, there was this idea of scrapping the top rate of income tax, which is 45% on over 150,000 pounds. So you don't need, you know, the top rate would be, you know, somewhat lower than that.

That was only going to cost two billion pounds a year. I say only two billion pounds a year, but there we go. It was a small part of that 45 billion package. But today, they also said, right, well, we're going to freeze various other budgets, and that will deliver 18 billion pounds of savings. So put those two together. That's actually, there's some substance there as well. You know, the market was looking for around about 30 billion unfunded tax cuts.

and that would be using up all the fiscal room from the previous OPR financial projection. And so it was a 35 up to 45. That was the element of surprise. And so the substance has been fully unwound in a way which I think a lot of people here will be horrified to find that public services which are falling apart are going to be impacted as a waiter to kind of pay for some of the other unfodded tax cuts. And then that sort of chef's kiss of tax cuts for the very richest is been removed. And that's very stylistic.

You know, I'm looking at all these charts on my screen. And again, if you just sort of put a hand over on the screen over last week, you have a bunch of lines, almost where they were before the tax cuts at this point. And I think it was you, though, and you've written like in the last week, I think like five or six blog posts and been a must follow on Twitter as always. But I think it was you that saying something like you can't, did you say you can't unburn toast? Was that your line? Yeah. So what does it mean?

starting now here, like on October 3rd, when people are thinking about, you know, we talk about, oh, well, this move should only happen once every 100 trillion years or something. No one said that. But like, now we've seen the move. Now we've seen that it's possible. And now that we can't unburn that. We can't unsee it, even if I put my hand over the middle of the screen. So what does it do for managers and they're thinking about risks that such a moves are now proven to be possible? Right, right. So there's this huge kind of, a thing. efficiency versus resilience, sort of battle, right? And one of the things that the UK government was keen to do was to reform Solvency II,

which is a bunch of insurance regulations, so that they would need to have less capital, dead capital, sitting at the sidelines just in case, you know, as part of resilience. Yeah. And, you know, what, they might well go through of that, and maybe that's even sort of sensible, but from a risk manager's perspective that's using, I mean, all risk models pretty much are fed with historical data of some description. And this is now in the history.

So every stress test that the asset managers or investment banks use, which are kind of different, like, scenario stress tests, you'll have one which will be, you know, sort of UK has a bit of a meltdown as one of those sort of stress tests. And you'll need to make your portfolio survive that stress test from now on. If you have portfolio risk that you're looking at within your portfolio risk system, your portfolio might look a little bit riskier than it did because simply that historical data is feeding it. And so if you've got a risk budget that you're working to, you might need to take a little bit less portfolio risk. I mean, it's, it just kind of goes

into the into the plumbing of risk systems on bank trading desks and portfolio managers. And it'll fall out eventually, you know, I mean, these things tend to be like exponentially weighted. So it'll, after a few years even, it'll, it'll kind of, you know, be a very modest thing, be more on a discrete scenario side. But it's now a exists on everyone's sort of blotter and it's going to inform decisions, whether people think about that consciously or whether it's just underneath. So this to me is the sort of big picture change that's happened over the past couple of weeks, which is this idea that we're all coming to grips with severe interest rate volatility.

And we can see government bond yields that are usually assumed to be relatively stable, move very quickly and very suddenly. And we've designed an entire financial system around the assumption that that doesn't happen very much. So we have a lot of bank capital rules, liquidity coverage rules, pension fund rules that tend to herd investors into these stable and ostensibly safe government bonds. And so when that doesn't happen, when they turn out to be really volatile, it becomes extremely painful and in some circumstances problematic. Is that a lot of. Is that, that like is that something you would agree with or how would we resolve that tension the idea that you know most big investors are supposed to hold a whole bunch of government bonds right but then

you know we get a week like like last week and suddenly those government bonds turn into a liability I should be careful about using liability when we're talking about pension funds but you know what I mean yeah yeah yeah I mean I think I think you sum it up brilliantly you're fantastic communicator. I would just caveat that a little bit, just in spirit of geekiness, in that, you know, for pension funds, the long end is the risk-free asset, simply because that's where the liability sit. But, you know, so on an unleathered basis, you know, having a load more, if there was enough duration, would be a great, great thing for them. I mean, they would be able to close the funding ratio and that's it. But because that market structure doesn't really facilitate

that to happen, then yeah, that's going to be a problem. You know, just going back to earlier Tracy asked, like, well, how should we sort of conceptualize or categorize the BEOA's intervention? Should it be considered QE or not? Or is it just some other kind of market operation? If guilt or government bonds are the, like by definition, are the definitional risk-free asset, then the central bank in any country can't just let them deviate too far. I mean, people talk about a bailout. But essentially, like, It sounds like they just have to step in. Yeah, I'd completely agree with that.

You have to have a government curve. You know, without that, and nothing else works. Right. Also, I mean, the sort of striking thing is there's a lot of talk about central banks losing control of the long end of bond markets. But then, as you pointed out, when the BEO announced its intervention, it actually seems to have had more impact than it might have expected. Yeah. No, absolutely. I mean, if people talk about losing control of the long end, it's not something that the Bank of England would typically want to have any control of at all. They'd want market expectations to shape that. But getting into a doom loop is going to be something which will cause systemic problems potentially. And so as a lender of last resort or market maker of last resort, you need to step in.

So Toby, we're going to have to wind up our conversation now. But I guess just going back to the big picture of what's going on with the UK government and UK market. What are you on the lookout for for next steps or developments that might inform the future path? So I'm kind of on the pension fund side. I'm sort of thinking that a bunch of pension funds will unfortunately have lost their hedges. And so, you know, will they be coming back into the market to actually buy long-dated bonds in order to, you know, which could cause a real rally from here at the long end? Some people I speak to in the market on the investment consulting side and hedge fund side, they're sort of thinking, right, is there going to be some kind of stop loss safari that goes on? That's a great term.

Because what was revealed during this whole debacle was that actually if you push up long-dated yields by 100 basis points, you can throw some of these structures into unwind. And so I think schemes are trying to manicly make sure they're in a situation. whereby once the Bank of England intervention ends, that that's not going to be possible anymore. So that's going to be very interesting to watch. All right. I love the idea of going on a stop loss safari. Yeah.

We'll watch for that. It's not as fun as it sounds. All right. Toby Nangle, thank you so much for coming on Oblots. Fantastic to talk with you as always. Thanks for having me. Great to speak to you. Thank you.

So it's been too long, Toby. We'll have you on. We'll have you on again soon to talk about how the stop loss. far as go. But that was great. Joe, I thought that was a fantastic conversation. And it did actually, I guess, help in my mind crystallize some of the, there have been so many big ideas floating around based off of the price action that we've seen over the past week. Yeah, I just think it was very helpful just to get that distinction between liquidity versus solvency and the context of pensions. Because it's easy to sort of like have this cruise. It's like, oh, the pensions, they have a lot of

guilt's, the value of the guilt's plunged. Oh, now they're insolvent. Actually, they're not insolvent, in large part because by the conventions of accounting, their obligations went down too. But this theme and the fact that we talked about it earlier in the year, like five months ago with commodity markets, we see how really fast moves in leveraged areas can create liquidity crises even when the fundamentals aren't so bad. Right. And this kind of gets to the central bank point that Toby was making as well, which is as fun as it is or as bizarre as it is, is to watch a central bank that is ostensibly reducing its balance sheet and embarking on quantitative tightening actually go back into the market and start buying bonds.

That's the role, right? Like that is the classic lender of last resort. You see a liquidity issue like this, not a solvency issue, a liquidity issue. They're supposed to step in. This is really key. And I tend to think, and this is where, you know, I get a little frustrated with some of the commentary because a central bank, is part of the modern financial infrastructure. And so I think people like to pretend that like, oh, like real capitalism or real markets is when the central bank is hands off and then,

you know, let the chips fall where they may. But I think like, you know, part of this, the central bank does exist. It's core to the system and part of its role is to stabilize, especially the government bond market for very good reason. I don't think that per se means it's like cheating or a bailout. I'm not, I'm not convinced that these. are like useful terms when describing the central bank playing its role. No, I think that's right. What I would say is it does seem like a very complicated place for the BEOE to be in. And, you know, the idea that tomorrow we could wake up and the conservative government has made some new announcement or a new U-turn.

Who knows? And the BOE is going to have to try to formulate the correct response to that. Like that does seem tricky. I completely agree. And I would say there's two things. But one is every central bank right now is an inflation fighting mode, right? None of them want to be using balance sheet policy. You know, they're all like QT of some sort.

And so the idea that like this is going to put QT on hold or that they might even have to expand their balance sheet, I think is an uncomfortable position to put in. But what I would say also to your point about responding to policies and something could change tomorrow. There could be a new tax cut or too high, you know, tax hiker. Who knows? We have no idea. But what I would say is, you know, I think going back to this, it's like, can they respond on the inflation side of the mandate? So if there's more spending or more tax cuts, okay, we're going to have to hike rates to hit our target, hike rates further, while also with, you know, with the left hand, while with the right hand making sure markets stay stable. It's a tricky situation.

Well, this kind of goes back to the whole designing a financial system around government bonds thing as well. And I think it was, Connor Sen had a great tweet about how. you know, it's not just the financial system, it's monetary policy as well. Yeah. Monetary policy works through changing the price of government debt. So if you want to change employment or inflation, you're going to have to do something to the price of government debt, which makes everything a lot trickier at a time when, you know, people are really focused on interest rate volatility. Yeah. All right, we should leave it there because we could talk about this for another two hours, probably. Let's leave it there. All right, this has been another episode

of the All Thoughts podcast. I'm Tracy Alloway. You can follow me on Twitter at Tracy Allaway. And I'm Joe Wisenthal. You can follow me on Twitter at The Stallwork. Be sure to follow our guest, Toby Nangle. He's at Toby underscore N. Follow our producer of this episode, dash beddit. He's at DashBot.

And follow our other producer, Carmen Rodriguez, at Carmen Armin. And if you're looking for even more discussion on the pound guilds and everything else going on in the British economy, definitely check out in the city. It's a new podcast from Bloomberg, UK. And it's hosted by Francine Lakwa and David Merritt. It's covered all these finance stories straight from the heart of London. Thanks for listening. This is Tom Keane, inviting you to join us for the Bloomberg Surveillance Podcast.

It's about making you smarter every business day. I'm Paul Sweeney. We bring you complete coverage of the U.S. market open. We cover stocks, bonds, commodities, even crypto, all the information you need to excel. And I'm Alexis Christophores. Bloomberg Surveillance also brings you the analysis behind the headline. We do that through conversations with the smartest names in economics, finance, investment, and international relations. We do all this live each and every weekday that bring you the best analysis in our daily podcast.

Search for Bloomberg Surveillance on Apple, Spotify, YouTube, or anywhere else you listen. On the East Coast, listen at lunch. And on the West Coast, listen as soon as you wake up. That's the Bloomberg Surveillance Podcast with Tom Keene, Paul Sweeney, and me, Alexis Christophores. Subscribe today, wherever you get your podcasts. Bloomberg Surveillance, essential listening each and every business day.