We Were Very Close to a Disaster Yesterday -Here’s Why

By Gary Brode, Deep Knowledge Investing

Tuesday evening, futures markets traded down on news that Apple was seeing lower than expected demand for the new iPhone.  On Wednesday, the markets rallied with the S&P 500 up 2.0% and the NASDAQ up 2.1%.  The reason was the Bank of England announced they would buy long-dated UK treasury securities.  The BoE made some noises that it wasn’t giving up on quantitative tightening to reduce the money supply in order to contain inflation.  However, it’s supplying liquidity to the long-dated part of the market and reducing liquidity to the short-dated part of the market.  Verbiage aside, this is not the QT we were promised.

The story of what happened is not only fascinating; but also, makes clear just how close the UK financial system was to collapse yesterday.  The BoE acted quickly because they feared that they were about to experience their “Lehman moment”.  That’s when the entire system starts to collapse and institutions fail.

Here’s What Happened:

Pension funds hold and invest assets so that when the owners of the pension retire, the fund can pay them a monthly stipend.  There are all kinds of pensions including “defined contribution” and “defined benefit” as well as various parties responsible for the payments and investment results including the pensioner, the pension fund manager, a corporation, or a government.  In the case of these UK pensions, there was a shortage of assets due to the decline in the bond market.

Because most pension funds need to make regular payments, they tend to hold a lot of bonds.  Over the past decade or so, interest rates have been incredibly low.  Less than a year ago, the yield on the 10-Year US Treasury was 1.3%.  Even more remarkable, less than a year ago, the UK 30 Year Gilt (the UK version of a Treasury Bond) traded at a .8% yield.  That shouldn’t be possible.  Given any inflation at all, you’d be buying a financial instrument with a negative real return for almost a third of a century.