Khan Capital | September 2022
Key Takeaways
- Kwarteng’s £45 billion in unfunded tax cuts, announced without an OBR forecast, triggered the most violent sell-off in the UK gilt market in modern history, with 30-year yields surging approximately 120 basis points in three sessions.
- The gilt sell-off triggered a margin call cascade in pension fund LDI strategies; Bank of England research found LDI selling accounted for half of the gilt price decline, with forced sales of £25 billion in five weeks.
- Sterling crashed to a record low near $1.035 against the dollar, while the Bank of England was forced into emergency bond purchases of up to £65 billion to prevent pension fund insolvency.
- The political consequences were swift: Kwarteng was dismissed after 38 days as Chancellor, and Truss resigned after 45 days as Prime Minister, the shortest tenure in British history.
- The crisis established a precedent with global implications: the Chicago Fed noted the structural vulnerabilities exposed and assessed implications for US pension funds.
On Friday 23 September 2022, Chancellor Kwasi Kwarteng stood at the despatch box and delivered what he called a “Growth Plan” for the United Kingdom. Within hours, the pound had crashed to its lowest level against the dollar since decimalisation. Within days, the Bank of England was forced into emergency intervention to prevent the collapse of the UK pension system. Within weeks, both Kwarteng and Prime Minister Liz Truss were gone. The UK mini-budget crisis stands as a masterclass in how fiscal policy can break a bond market, and how a broken bond market can destroy a government.
What Happened: The Growth Plan That Imploded
Kwarteng’s mini-budget announced £45 billion in unfunded tax cuts, the largest fiscal loosening in a generation. The abolition of the 45p top rate of income tax, a cut to the basic rate, the reversal of planned corporation tax increases, and the scrapping of the cap on bankers’ bonuses were presented without an accompanying Office for Budget Responsibility (OBR) forecast.
Sterling plunged from approximately $1.12 to below $1.04. The 30-year gilt yield surged by nearly 120 basis points in three trading sessions, one of the most violent moves in the history of the UK government bond market.
The LDI Crisis: When Pension Funds Face Margin Calls
The gilt market sell-off triggered a crisis in liability-driven investment (LDI) strategies. UK defined-benefit pension funds use LDI strategies to match the duration and inflation sensitivity of their assets with their long-dated liabilities, typically involving derivatives and leveraged gilt positions. The Chicago Fed found that the steep decline in gilt prices “was amplified by structural vulnerabilities of UK defined benefit pension funds to large changes in interest rates.”
When gilt prices plummeted, pension funds received margin calls on their derivative positions. To meet these, they were forced to sell gilts, pushing prices lower still and generating further margin calls. The Bank of England estimated that LDI selling accounted for half of the decline in gilt prices during this period, with fiscal policy accounting for the other half. LDIs sold approximately £25 billion in gilts in the five weeks following the mini-budget.
By Wednesday 28 September, the Bank of England judged the gilt market was on the verge of a dysfunctional spiral. Governor Andrew Bailey announced an emergency bond-buying programme of up to £65 billion in long-dated gilts. The intervention was extraordinary: the BoE was buying bonds to stabilise the market at the same time it was supposed to be selling bonds as part of quantitative tightening. The IMF later analysed the BoE’s response as a key case study in financial stability intervention.
What the Market Is Misunderstanding
This was not primarily a currency crisis. Sterling weakness was a symptom of the loss of fiscal credibility; the gilt market dysfunction was the disease.
The LDI mechanism was the amplifier, not the cause. LDI strategies worked as designed for decades. The problem was the degree of leverage and the assumption that gilt market moves would remain within historical bounds. Durham University noted that regulators “had woefully inadequate data” about LDI positions when they needed it most.
The bond vigilantes are real. The UK experience is the clearest modern demonstration that sovereign bond markets can and will discipline governments that pursue fiscal policies deemed unsustainable. The speed and violence of the gilt market’s reaction showed that the market’s verdict on fiscal credibility is delivered in hours, not months.
The absence of an OBR forecast was the critical error. Markets can process bad news; what they cannot tolerate is the absence of information.
Structural Interpretation: The Limits of Sovereign Fiscal Space
First, the interaction between fiscal and monetary policy has become a first-order risk factor. When a government pursues expansionary fiscal policy while its central bank pursues contractionary monetary policy, the tension manifests in bond markets with potentially explosive consequences.
Second, leveraged positioning in sovereign bond markets creates hidden fragility. Similar leverage structures exist in other markets, including US Treasury basis trades, and would be vulnerable to analogous shocks.
Third, the political consequences of bond market crises are immediate and severe. Kwarteng was sacked after 38 days. Truss resigned after 45 days, the shortest tenure in British history. Bond markets are more powerful than prime ministers.
Implications for Investors
Fiscal credibility is now a priced risk factor for developed market sovereigns. The UK crisis demonstrated that G7 government bonds are not risk-free when fiscal policy deviates sharply from market expectations.
Pension fund leverage should be monitored as a systemic risk indicator. The LDI crisis revealed that the pension system can become a source of procyclical instability when leverage is excessive.
The playbook applies globally. Any government contemplating large-scale unfunded fiscal expansion while its central bank is tightening should study the UK experience. The US, with its own growing fiscal concerns, is the most consequential potential arena for a similar dynamic.
Conclusion
The UK mini-budget crisis of September 2022 will be studied for decades as the defining example of how fiscal policy can break a bond market and how a broken bond market can cascade into a pension system crisis, a currency rout, and a political collapse, all within a matter of days.
Sources: Bank of England (Bank Underground), Federal Reserve Bank of Chicago, International Monetary Fund, EFG International, Durham University Business School
Related Reading
The UK gilt crisis was part of the broader fixed income carnage covered in The Global Bond Bear Market: Worst Year for Fixed Income in Centuries. For the rate hiking cycle that created the backdrop, see The Fed’s Most Aggressive Hiking Cycle in 40 Years. For the ECB’s parallel tightening, see ECB Finally Hikes: End of Negative Rates in Europe. For a later example of bond market dysfunction, the March 2020 liquidity crisis provides a useful comparison.
Leave a Reply