What exactly is the threat to financial stability?

The threat to financial stability is real enough, writes Robert Peston. Credit: PA

If government bond sales by pension funds are the fundamental cause of a potential systemic crisis that could hurt us all, as the Bank of England says, why are pension funds taking so little advantage of the Bank’s offer to buy £65bn of the bonds, and why are bond prices still falling?

It seems to me the only explanation for what is happening is that margin calls on pension funds’ LDIs - or the trillion pounds of their debt that’s secured against UK government bonds - are not in fact the main cause of the spike in bond yields, or at least they are only a small part of it. It is the other way round.

The spike in bond yields is prompting margin calls, which is then causing pension funds to sell assets, of which gilts are only part.

This is not a market's tail wagging the economic dog, as to an extent happened in 2007/08, but an economic dog, high on fiscal stimulus, biting off its markets tail.

And if that is the case, you would not expect the pension funds to use much of the Bank of England’s £65bn facility, because they are flogging other stuff to cover bond losses.

And the worry of course is that the £65bn facility - even if take-up is low - is pro-inflationary.

And that reduces confidence of investors that the Bank and government can and will take necessary and sufficient action to bring down inflation, the very inflation which is driving down bond prices and driving up bond yields.

Or to put it another way, the fundamental threat to financial stability stems from a mini-budget that spooked investors by stimulating inflation and creating a £60bn a year black hole in the public finances, coupled with a concern that the Bank of England’s anti-inflation credentials are not what they should be.

The threat to financial stability is real enough. But the excessive debt or leverage of pension funds - a failure of regulation if ever there was one - is only a proximate trigger.

The fundamental cause is investors’ lack of confidence in the institutional competence and anti-inflationary determination of Treasury/Downing Street and the Bank of England.

This is fundamentally Kwarteng and Truss’s mess, with a bit of help from the Bank of England.

And the worry is that once confidence erodes, all the reverse ferrets in the world - OBR reinstated, Treasury lifer given top Treasury job, and so on - will struggle to restore it.

By the way, if the fundamental threat to financial stability is - as I argue - the unfunded tax cuts, a restoration of stability requires the chancellor to cancel or massively delay the cuts (and increase corporation tax as per Sunak’s plan).

But I don’t think there has ever been a U-turn on that scale in modern politics.

Kwarteng could not survive that humiliation and it is not clear the PM could either, because the big money cuts were her summer leadership pledges.

This is a monster of an interconnected political and economic crisis.

What do words like gilt and bond mean?

What is a gilt?

Gilts are essentially loans given to the government, also known as government bonds.

The government sells gilts to raise money for their spending plans. In return, investors who buy these gilts are paid interest each year until it is time for the government to repay investors in full.

For example, if an investor buys a gilt for £100,000 at an agreed rate of interest of, say, 5% over ten years, then the investor will get 5% of £100,000 (which amounts to £5,000) each year (or over another agreed period of time) until it is time for the government to give back £100,000.

The deadline for the government to repay is known as the maturity rate.

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What is a bond? And what is a yield?

The yield of a bond is, simply put, the amount of money an investor receives for buying that bond.

Bonds are loans to the government – also known as gilts, as explained above – and the money the investor makes from the bond depends on the yield.

The yield is essentially the interest paid for the bond.

If an investor loans the government £100,000, this amount will be paid back in full at an agreed date in the future. In the meantime, the investor is paid interest on that loan at an agreed rate.

For example, if the interest is 2% then the investor would be paid £2,000 at the end of each agreed period – which could be a year. This is what the bond yield is.

Higher bond yields may indicate investors are reluctant to buy bonds.

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What is inflation?

Inflation represents the change in price level over a year.

Each month, the Office for National Statistics checks the prices of a range of items in a ‘basket’ of goods and services.

They look at the cost of more than 700 things people regularly buy, including everyday things like a loaf of bread and a bus ticket and larger ones, like a car or holiday.

To calculate the rate of inflation, they compare the cost of the basket with what it was a year ago. The change in the price level over the year is the rate of inflation.

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