The Bank of England said its intervention last month in the gold market prevented a “self-reinforcing spiral” after Kwasi Kwarteng’s mini-budget, which could have wiped out the value of large numbers of funds held by pension firms.
In a letter to the House of Commons Finance Committee outlining the thinking behind the dramatic move on September 28, the Bank’s deputy governor for financial stability Sir Jon Cunliffe said soaring bullion prices could have caused “broad economic instability”.
Had the Bank not intervened, a “large number” of liability-based investment (LDI) funds would have been left with “negative net asset value”, reducing to “zero” their value to pension providers with significant stakes in them.
That would have triggered an “excessive and sudden” rise in lending rates in the wider economy, Sir Jon said.
On the morning of September 28 – five days after markets were spooked by Mr Kwarteng’s £45bn package of unfunded tax cuts – the Bank announced it was ready to pump unlimited amounts into female to stabilize prices, capped at 5 £ billion a day. to be sufficient.
The action is set to continue until October 14, bringing the Bank’s maximum planned intervention up to £65bn. But Sir Jon said that by Wednesday this week it had only proved necessary to deploy £3.7bn of its potential firepower, as the announcement itself had the effect of calming markets.
Citing the scale of the market chaos that prompted the unprecedented intervention, Sir Jon told the committee that on Monday after Mr Kwarteng’s statement on Friday, yields on 30-year gold – essentially the interest the government has to pay for borrowing of – had increased by more than 0.8 percentage points.
Gilts are a financial instrument preferred by pension funds because of their reliability over the long term and market volatility is extremely uncommon.
“Throughout the day and into the evening, the Bank received market intelligence of increasing severity from a number of market participants, and in particular LDI fund managers, who indicated that conditions in key markets, if they continued to deteriorate, would they were forcing them to sell large amounts of long portfolios in an increasingly illiquid market,” Sir Jon said.
“At face value, this market intelligence would result in additional long-term gold sales of at least £50bn in the short term, compared to recent average market trading volumes of just £12bn per day in these maturity sectors.”
After a brief rally early on Tuesday, yields rose a further 0.67 percentage points later in the day “substantially worsening the situation”, he said.
“The Bank was advised by a number of LDI fund managers that, at prevailing yields, multiple LDI funds were likely to fall into negative net asset value.
“As a result, it was likely that these funds would have to start the liquidation process the next morning.
“In this event, a large amount of pockets, held as collateral by banks that had lent these LDI funds, were likely to be sold into the market, leading to a potentially self-reinforcing spiral and threatening severe disruption of key funding markets and consequently widespread financial instability”.
He told the cross-party panel of MPs: “Had the Bank not intervened on Wednesday 28 September, a large number of LDI pools would have been left with a negative net asset value and faced shortfalls in the collateral deposited with bank counterparties.
“Defined benefit (DB) pension fund investments in these LDI pooled funds will be worth zero.
“If the LDI funds defaulted, the large amount of pockets held as collateral by the banks that had lent to these funds would then be sold in the market.
“This would increase pressures on the financial system and further damage the gold market, which in turn would force other institutions to sell assets to increase liquidity and increase self-reinforcing declines in asset prices.
“This would have resulted in even more severe disruptions to the functioning of the underlying gold market, which in turn may have led to an excessive and sudden tightening of financing conditions for the real economy.”