Its Over, page-14698

...do we truly understand all the nuances of the bond market and the derivatives used in hedging?

...the hedged derivatives are souring because they were acquired under a long held assumption that rates would remain low for a considerable time, so long no one would have expected they would rise so much so fast, and the assumption that oil having fallen below $0 during the Covid crash would be at their normal ranges, an assumption thrown asunder by the Ukraine war.

...but one thing we should and ought to remember is this - it is an INTERCONNECTED world, hedges subject to margin calls must be met by liquidation of whatever that is available to be liquidated in a hurry into cash.

...we could be nearer a systemic event , stay guarded and stay safe. The problem is that we are so used to increase volatility these days that we no longer give too much oxygen to the next one that appears....at some point it won't be the market crying wolf.

It could happen here: why super funds face cash crunches

The intervention by the Bank of England has exposed how pension funds can be forced into panic. But there are limits to what central banks can do to avert crisis when they are supposed to be starving inflation.

Jonathan ShapiroSenior reporter
Sep 29, 2022 – 10.33am

The United Kingdom lurched from budget crisis to an outright financial crisis in a matter of days. The Bank of England appears to have done enough to keep the bailout hawks at bay.
Chancellor Kwasi Kwarteng's aggressive fiscal spending plan was met with revulsion of epic proportion by currency and bond traders, triggering a savage rise in Gilt yields and a plunge in the value of the pound to a record low.

There was already a debate raging around whether the UK was descending into emerging market status, but suddenly Ray Dalio and Larry Summers were calling it just that. And then came scathing comments from the International Monetary Fund.
The extraordinary movement in bond yields has forced the Bank of England to intervene in the bond market, a move that runs directly counter to its strategy of winding down its balance sheet and raising interest rates to arrest high inflation.

Why? As Hans van Leeuwen explains, the BoE’s hand was forced by a brewing solvency crisis among pension funds.


It's well known that pension funds, particularly those holding standard portfolios of 60 per cent stocks and 40 per cent bonds, have taken a beating this year. But their derivative exposures are less well understood.

Several explainers have been circulating about liability-driven investment (LDI) trades enacted by UK pension plans.

We wrote about how rising bond yields helped turn large pension deficits into surpluses as future liabilities owed to members are discounted to a present value at a higher rate, mathematically reducing them.

However, UK pension funds use long-dated interest rate swaps and derivatives to hedge these long-term liabilities which had ballooned due to sustained low interest rates. This involves posting a modest amount of margin freeing up cash to invest in other assets, such as stocks, private equity and debt.

The collapse in the value of those swap positions left UK pension funds in a desperate scramble for cash. Some simply couldn’t find the money in time, it seems. And that may have been enough to compel the BoE to step in.
It’s almost identical to the issue that Australian superannuation funds faced in 2008, then in March 2020, and may be facing again as a result of the falling Australian dollar.

Australian super funds have a large stockpile of offshore assets, which are largely but not entirely currency hedged.
The risk for a local super fund is that if the Australian dollar appreciates, US- or euro-denominated assets fall in value. So funds hedge against that risk by buying currency derivatives that are, in effect, long Aussie dollar positions.

When the currency falls, the gains in the value of those assets is simply offset by the fall in the value of the hedges. But the issue becomes the hedge, which is now deeply in the red, and the counterparty is sitting on a large gain and demanding collateral.
That forces super funds to raise cash to satisfy the counterparty. (For Australian banks that hedge their foreign currency debts by currency shorting, the opposite occurs. They are flooded with cash when the currency declines).
Markets clog up

These hedges are mathematically effective. It’s the size and speed of these moves that triggers short-term desperation for cash and rapid liquidation behaviour.

However, it must be recognised that the incredible destruction in bond values – meant to be safe assets – will be felt by pensioners.

A further twist is that this quasi bailout of pension funds was caused by them taking on hidden leverage to counter the adverse effects of ultra-low interest rates.

And once again, the bond market may have ceased to function. It certainly wouldn’t be the first time. The sovereign bond market is essentially an over the counter market run by a panel of banks that are certified dealers.


Most of the time, the bond market operates fairly smoothly but when these dealers are inundated with sellers, there’s only so much stock they can take on before they have to turn sellers away.

That was the case in March 2020 when the Reserve Bank intervened in the Australian government bond market. It did so in the name of restoring orderly functioning to a key benchmark as opposed to targeting a level of yield or engaging in quantitative easing.

These issues also tend to be more acute at the end of the financial quarter, when brokers' risk positions are measured for regulatory purposes.

We have little doubt that this bond market sell-off will have systemic consequences. The extent to which central banks can juggle their crisis response function with the imperative to stem an inflationary outbreak remains to be seen.