The most significant thing that happened this week was that the Bank of England announced they were buying 30Yr Gilt bonds in a reversal of their recently announced policy to sell bonds and raise interest rates. The most curious thing about the announcement was that it would only last until October 14th. Given the amount of money lost in the bond market this year, my initial reaction was that this was a rescue attempt of some sort and my gut reaction was correct.
The Power of Leverage
When central banks engage in quantitative easing and ultra-low interest rates (2009-20022), an unnatural environment of low volatility is created so that asset prices (stocks and junk bonds) can float higher and create asset wealth. However, this action robs the system of safe yield for retirees, pension funds and risk averse investors who must turn to the beast of leverage to gain interest income.
SO, let me introduce you to Liability Driven Investment (LDI). This is the product that many UK pension funds bought to satisfy their obligation to retirees. Not that this is what they wanted but it was the only thing they could buy when yields were being suppressed by central banks.
Essentially, these pension funds bought leveraged positions in long-dated UK GILT bonds to make a return so that retirees could live off their pension. Unfortunately, the parabolic rise in UK 30Yr yields (see chart above) means bond prices tumble double-digits and that triggered margin calls on the LDI participants.
The size of this pothole for the pension funds is a mystery to me but it was large enough for the Bank of England to come to the rescue and provide liquidity so that these trades could be unwound. I am sure we will find out who the losers were on this trade in the coming weeks but it makes me think about how many more leveraged trades are in the system and that more volatility is coming for long-term bond holders across the globe.
What Happens Next?
The reversal of quantitative easing is resulting in lower prices for the majority of stocks. As the chart below shows, the S&P topped in January of this year and bounced in June up to the August high of $432 in the S&P 500 ETF (SPY) below. On Friday we breached the June low and now the door is open to much lower levels and perhaps the bottom of this chart will be re-visited if the current market conditions persist.
Of course, the central banks could reverse course but that would re-ignite inflation and Fed Chair Powell keeps using the word “resolve” in his speeches so it is a good bet that policy will remain unchanged for the remainder of this year (at least).
The third quarter ended on a whimper and the preliminary look does not look good. This week we got earnings from semiconductor manufacturer Micron and Nike and there were three commonalities: 1) Both lost money on overseas earnings 2) Both had issues with excess inventory 3) Both experienced a sharp and unexpected decline in their businesses mid-quarter. Unfortunately, I think this will be the theme in Q3 earnings which will kick-off in two weeks.
- Initial jobless claims fell to 193k which means there is no weakness in the jobs market and gives the Fed license to keep raising rates as long as the job market remains “strong”.
- Core durable goods orders in August rose 1.3% compared to July which was good and well above the estimate of +0.2% and July was also revised up by 0.4%.
- The August headline Personal Consumption Expenditures (PCE) inflation figure was up 0.3% compared to last month and the core rate was up by 0.6%. Versus last year, core PCE was up by 4.9% after a 4.7% rise in July. This is the Fed’s
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President, Kisco Capital