ALEX BRUMMER: The Bank of England ignored its own alert over LDIs

The cautionary note explaining the Bank of England’s extraordinary bail of £65bn bond market appears on page 54 of its November 2018 Financial Stability Report.

It states that it is ‘not clear’ whether pension funds and insurers pay sufficient attention to the liquidity risks associated with the use of LDI (Limited Driven) programs that are intended to improve the returns of gilts.

The Bank has committed to working with other enforcers – the Prudential Regulation Authority (a branch of the Bank), the Pensions Regulator and the Financial Conduct Authority – to monitor all things that can go wrong, from a lack of cash to losses caused by non-bank debt or credit.

It all went well then!

Four years after the Bank’s sotto voce warning, taxpayers must save a market with life savings and pensions of 10 million people. It shouldn’t be hard to see this coming.

City players BlackRock, Schroders, Legal & General et al. have invented a wonderful tool, using borrowed money, derivatives and other techniques, to improve the performance of gold-plated wallets.

Paradoxically, the aim was to bolster the financing of private sector pensions, many of which were in deficit. It took off like a rocket and markets tripled to £1.5 trillion in ten years.

Lord (Simon) Wolfson, Britain’s most impressive retailer, says he was so concerned about the financial sector’s love affair with LDIs, after enduring many sales pitches, that he wrote and proposed to the Bank of England in 2017 take action to address the risk.

As was the case in the years leading up to the financial crisis and in the Libor interest-setting scandal, the Bank’s ability to process intelligence and act on it was lacking.

Only with the prospect of bankruptcies coursing through the financial system and affecting the entire pension structure, it went to the Treasury and launched a lifeboat, having first secured compensation.

The same bank that was oddly reluctant to lift EU regulations, fearing that pension funds and insurers could invest in risky assets such as infrastructure, faced a potential catastrophe.

The Bank can rightly point to some extraordinary circumstances, with the pound under pressure and the long 30-year gold plating plummeting in value.

Neither would have happened if the rate-setting Monetary Policy Committee (MPC) had been bolder at its September meeting.

The members may not have been fully aware of Chancellor Kwasi Kwarteng’s supply side, but they knew that the Federal Reserve had raised interest rates by three-quarters of a percentage point.

The US central bank has taken decisive action to cut a rate of inflation caused in part by a monetary splurge. By widening the gap between UK Treasury and US Treasury yields, the MPC left an open target, which was looted by traders.

But no one should think that the current bond tantrum is a uniquely British problem. As the FT reported this week, the much larger and more important US $24 trillion bond market has recently been hit by its biggest turbulence since Covid-19. It then needed massive intervention from the Federal Reserve to prevent the entire financial system from taking a hit.

Andrew Bailey, the governor of the Bank of England, played a role then (as now) by partnering with other central banks and setting up dollar swap deals designed to bolster confidence.

The bond market tantrums and the fire and brimstone of the Fed and other central banks are exaggerated in the eyes of veteran monetarist Patrick Minford.

Monetary expansion on both sides of the Atlantic has been reduced to zero and as the global economy slows down and slides into recession, inflation will disappear as quickly as it started. Minford predicts that consumer prices in the UK will fall to 5 percent next year – a striking argument that runs counter to the current consensus of Wall Street and City brokers.

The herd instinct in the financial markets has undermined LDI strategies for pension funds.

And sloppy, unfocused regulation by the Bank of England et al exposed pension funds to crippling risks.