Lessons from a small island. This could get really nasty if we are not careful.
Truss is toast
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Truss is toast. But so are we if we are not careful: financial vulnerabilities loom large in the global economy. The U.K. has trashed The Treasury, The Bank of England, The OBR, The Tory Party and the Asset Management industry. Let’s see who mounts the best comeback. Or any comeback.
There is one herd of elephants in the room: Brexit. The U.K. is tearing itself apart because the cake - the economy - is, at best, stagnant. And has been since 2016. Liz Truss is right about the problem. But just so hopelessly wrong about the problem’s cause and, therefore, solution. Brexit isn’t the only thing going wrong but it’s at the top of a long list of things that need to be tackled if the cake is to grow again. Until then, Britain will descend further into factional squabbling, crisis and global insignificance. If you keep pretending that Brexit isn’t part of the problem, the problem will grow.
Bond markets should be as interesting as household plumbing but both are messy when they go wrong, The blow-up caused by higher U.K. bond yields serves as a warning: regulators have yet again been asleep at the wheel and allowed too much leverage to build up in sleepy corners of the financial system. The British asset management industry has covered itself in glory by allowing self-serving advisers to sell inappropriately leveraged investment products to naive pension trustees.
Another warning: macho central bankers determined to send the world economy into recession to cure inflation need to be very careful. The detonation of the U.K. pension fund industry shows us what can happen when interest rates rise too fast and by too much.
Three (at least) lessons will have to be relearned. Regulators need to stamp on leverage, inside and outside the banking system. Investment advice should be avoided when it is free or cheap. The investment industry is still riddled with conflicts of interest: beware the adviser who tries to sell you something other than advice.
We won’t solve the housing or climate crises until we allow building - high rise accommodation in our cities, wind and solar farms in the country. Get serious: it’s a war for survival. Tell the NIMBY’s who moan about spurious shadows that they have much more to fear than being overlooked. If you can’t persuade them then just buy them off.
Hi Lads. Some interesting facts I read this morning:
- during Liz Truss’s eight minute press conference on Friday, the 10 year swap rates moved 20bps. That’s over 2.5bps per minute!
- in the last two weeks, the UK had more than 30bps interest rate swings in one day, and USD to GBP FX rates moving more than 2.5% in a single day.
Extraordinary.
Hi Lads. Thanks for the latest podcast
The pension industry discussion is boring to most but interesting to me. I found this article really good:
https://www.ft.com/content/6ca2ff89-e59b-4529-8448-4c09b27af480
The “search for yield” has been a huge pension issue. If all pensions were backed with “risk-free” government bonds, our pension pots wouldn’t be getting us very far at all. This is generally solved by taking on some risk, and that risk is credit and liquidity risk. Without it, we’d all be complaining.
For life insurers, there is massive business in buying out these old DB schemes. That may accelerate in the wake of the LDI crisis.
But life insurers are also tasked with this search for yield. An insurer is only competitive in this market if they’re backing these liabilities with highly illiquid assets, and there’s a bit of a race to the bottom on this. This approach is fine in theory if you can match the asset and liability payments exactly. In the EU and the UK, there is strong regulation around demonstrating you’ve done this.
But it is very hard to perfectly match the specifics of your liabilities with illiquids alone. By their nature they are infrequently traded, and the insurers have a very specific liability profile to match. So that’s where the derivatives are supposed to come in. Swap out risk free for durations you don’t want and buy into the durations you need. That’s how it’s supposed to work. But this derivative positions come with margin accounts and collateral that needs rebalancing with liquid assets.
A big challenge with markets moving so extreme so quickly. It is worth noting that insurers are technically supposed to be capitalised against 1-in-200 year events over a 12 month time horizon. But the interest rate rises since the beginning of the year are in the ballpark of that type of stress. We are witnessing a very extreme event this year.
All too often, those portfolios of illiquid assets are making their way offshore to countries like Bermuda, where reinsurers can take greater credit for those higher yields than is allowed by EU or UK regulators or have poorer liability matching rules. Yet their regulatory regimes are technically “equivalent” - go figure! This is a massive risk. In effect, there is a trend for all our pension money to end up offshore where regulations (or enforcement of them) are more relaxed, with more risks being taken with the money than our domestic regulators would allow. What could possibly go wrong with that?
By the way, for experienced financial professionals a job with the regulator would require a pay cut of around 50% in my opinion. But you often finish by 4pm on a Friday.