A Brief History of the Past 10,000 Years of Monetary Policy

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That’s Wall Street on the left and UK pension funds on the right.

To explain, I need to give you a quick review of the last 10,000 years of market history.

Don’t worry, it’ll just take a sec.

In the beginning, someone with a business wanted money from someone with money.

There are two and only two voluntary (i.e., without the threat of physical violence) ways of doing this. In exchange for the money, the person with a business can promise the person with money a share of the future economic activity of the business, or they can promise to repay the money in the future along with more money. In general, we call the former promise “equity” and the latter promise “debt”, and people with money have been collecting these promises from people with businesses since money was invented. These collections of promises are called “investment portfolios”.

About a nanosecond after money and equity and debt were invented, the business of facilitating these transactions was invented. Today we call this business “Wall Street”, but of course it goes back thousands of years, way before there were things called streets. The business of Wall Street consists of two and only two things: thinking up news ways to create a transferable share of some future economic activity, and thinking up new ways to borrow money today for a promise to repay that money and more in the future. We call the former activity “securitization”. For example, equity promises are securitized into “stocks” and debt promises are securitized into “bonds”, which makes the sale and resale of these promises sooooo much easier. We call the latter activity “leverage”, which is just a ten-dollar word for borrowed money.

Every bit of financial innovation over the past ten thousand years or so – all of it! – has been in service to one or both of those two activities: securitization and leverage.

About a nanosecond after Wall Street was invented, the people with a local monopoly on the legitimate use of violence (“governments”) noticed that the price of leverage – the amount of more money that had to be repaid to the people with money as part of the securitized debt (i.e., bonds) in their investment portfolios – ruled the economic lives of the people over which they had a local monopoly on the legitimate use of violence. So governments decided that they needed to control (or at least try to control) the price of leverage, which today goes by the name of “interest rates”.

In the modern context, this effort to control interest rates is accomplished by a bureaucracy within the government executive (a “central bank”). In addition to shaping the price of leverage through interest rates, these central banks are also charged with providing emergency cash (“liquidity”) to buy securitized things when all the people with money are so freaked out that they are no longer voluntarily willing to buy those securitized things.

Central banks shape interest rates in three ways.

1) The first and most traditional way is to change the interest rate they pay regular banks for the money those regular banks keep with the central bank (called “reserves”).

This money is “borrowed” by the central bank on a very short-term basis (typically day to day), and sets the price of borrowed money upon which all other borrowings and instances of leverage are based. In the US, this most basic price of leverage is called the Fed Funds rate, and when Jay Powell says that the Fed has hiked interest rates by 0.75% he is talking about this. The Fed Funds rate today is 3.25%.

So that’s the interest rate paid by the safest borrower in the world for the shortest amount of time. If you’re not as safe a borrower, then you have to pay a higher price for your leverage. If you’re borrowing money for a longer period of time, then you also have to pay a higher rate of interest.

Sometimes a government can borrow money long-term at a cheaper rate than short-term, like today the 10-year US Treasury has a lower interest rate than the 2-year. This is called an “inverted yield curve” and is a signal that the buyers and sellers of government bonds think that the longer-term strength of that economy will be weaker than the shorter-term strength of that economy, and thus won’t support as high a rate of interest. But this only happens with governments, not people, and it’s rare even for governments.

2) The second way that central banks shape interest rates is by directly buying and selling bonds.

This buying and selling mostly takes place in government bonds, but can take place with corporate bonds or mortgage bonds, too. Central banks do this because the price of a bond goes up or down inversely with interest rates. Think of it this way … you buy a 10-year Treasury with an interest rate of 3% per year from the US government for $100, which means that they promise to pay you back your $100 in ten years, and along the way they will pay you $3 per year in more money ($30 total over ten years). You can turn around and sell this promise by the US government for $100 to someone else if you like. But let’s say that next week someone else gives the US government $100 for 10 years and the US promises to pay that back with a 4% interest rate. That person will also get their $100 back in ten years, but will receive $4 per year in interest ($40 total). You will now get less than $100 for your 10-year Treasury with a 3% interest rate if you try to sell it to someone else, because $100 can now get you the same 10-year promise from the US government, but with a 4% interest rate. The market price of your portfolio of promises to repay you more money in the future goes down if interest rates go up, and the market price goes up if interest rates go down. Hold that thought!

So if central banks want to make interest rates go down (the usual goal), they buy vast quantities of bond, which drives the price of the bonds up (more buying on same supply = higher prices) and the price of leverage, aka interest rates, down. This is called “quantitative easing” or QE. Today the Fed and other central banks are selling off some of the vast quantities of bonds they have bought over the past 15 years, in order to push the price of the bonds down and interest rates up, and thus (they hope) put a lid on inflation. This is called “quantitative tightening” or QT, and the market hates this.

3) The third way that central banks shape interest rates is with their words.

This used to be called “jawboning” but is now called “forward guidance”. It’s an effort to change investor expectations of future central bank actions without actually raising or lowering short-term interest rates (option 1) or buying or selling vast quantities of bonds (option 2).

Using words is a very cost-effective way of shaping interest rates if markets believe you will do what you say you will do! This is called “credibility” and everyone is always trying to figure out if central banks have lost or gained credibility.

For the past 30 years, central banks have kept interest rates artificially low, first through option 1 and more recently (since the Great Financial Crisis in 2008-09) through options 2 and 3. And because of the inverse relationship between interest rates and the price of the bonds themselves, everyone’s investment portfolios were kept artificially high and the people with money got richer at a faster rate than the people with businesses grew their businesses. Wheee!

Hollow Men, Hollow Markets, Hollow World

Central banks were able to do this (keep the price of leverage, aka interest rates, artificially low) without creating massive inflation because international capital flows to build factories and make stuff in countries with cheap workers (“globalization”) kept wage inflation and goods inflation low, and governments didn’t go completely crazy with giving away money for people to spend. Until the pandemic, that is, when globalization ended and governments went completely crazy giving away money for people to spend, and we all knew that we all knew this was the case, and so inflation erupted all over the world. So now central banks can’t keep the price of leverage artificially low, even though the amount of leverage sloshing around in the world is historically, insanely high.

Okay, one more thing to cover before getting to how the UK has exposed the catalyst that blows up the financial world, and that’s the relationship between interest rates and currencies.

In the short and medium term, the exchange rate between two currencies (at least among the big, developed economies) is largely a function of relative interest rates between the two countries and expectations of future relative interest rates between the two countries. There is a direct relationship between interest rates and currency value, so that higher interest rates drive a stronger currency. This makes sense, right? All other things being equal, if country A pays more money on what they borrow in their currency than country B pays in their currency, people with money will sell country B’s currency to buy country A’s currency and get the higher interest rate.

Over the last six+ months, the Fed has been really hawkish in words and deeds (options 1, 2 and 3), which has led to a really strong dollar versus every other country in the world. For all the countries suffering a weaker currency, the good news is that exports to the United States are now cheaper from the US perspective, so you can export more (yay!). The bad news, though, is that everything you import that is priced in dollars (i.e., American goods and services and Middle Eastern oil) is a lot more expensive from your perspective (boo!). A weaker currency imports inflation, which is a lot more damaging to big, developed countries today than stronger exports are helpful.

And now to the UK debacle. First, some terminology that you might run across. UK government bonds, what we would call Treasuries in the US, are called “gilts”. The UK currency, which is the pound and is abbreviated GBP, is also called “sterling”. The exchange rate between the USD and the GBP is sometimes called “cable”. Members of the Conservative Party in the UK are often called “Tories”. The head of the government financial bureaucracy, what we would call the Treasury Secretary in the US and most countries would call a finance minister, is called the “Chancellor of the Exchequer”. There’s a long and boring story behind all of these words, of course, but I just want you to know what they mean when you read them.

The Bank of England (the central bank of the UK) was actually earlier to start hiking interest rates than the Fed, but they’ve slowed down more recently and – like every other country – the pound had gotten a lot weaker versus the dollar. For example, after the Fed recently hiked by 0.75%, the BoE only hiked by 0.50%. They’ve been cautious to raise rates as quickly as the Fed because – as much as they’d like a stronger currency to tamp down imported inflation – they also don’t want to completely crush the domestic economy with a recession created by higher interest rates. But the Bank of England is not the catalyst of the problem here!

The first catalyst for the problem here is the newly installed Conservative Party leadership (Liz Truss replaced Boris Johnson as Prime Minister and brought in a new Chancellor, Kwasi Kwarteng) and their newly announced tax cuts for corporations and the rich, combined with their ongoing support for directly subsidizing household energy costs. These plans mean a lot less money coming in from taxes and a lot more money going out in payments, which just pours gasoline (“petrol”, I suppose for another funky Brit word) on the already raging inflation fire.

Kwasi Kwarteng and Liz Truss looking for their credibility

As soon as the Truss/Kwarteng plan was released, expectations skyrocketed that the Bank of England would be forced to raise interest rates far more than planned in order to contain this new source of inflation. And since when interest rates go up, the value of UK bonds go down, many people with money started selling those UK bonds. Selling those UK bonds drove the price of the bonds lower still, which created still more upward pressure on interest rates. Which created still more pressure to sell. You see the problem? Well … it gets worse.

This brings us to the second and actually far more important catalyst for the problem here, which is what UK pension funds – who control about $1.6 trillion in assets – have been doing with their money.

It’s not actually their money, of course. Pension funds get money today from workers and pay back that money to workers when they retire, some decades in the future. Pension funds are the epitome of long-term investors. Or they should be, anyway. There’s no way that a short-term spike in interest rates should create a crisis across $1.6 trillion in UK pension assets! So what if interest rates spike up and their bond portfolio takes a temporary hit? A pension fund should be able to ride out the short-term ups and downs of markets (“volatility”) and capture the long-term benefit of owning a portfolio of stocks and bonds, right? A pension fund should never be forced to sell their bonds into the teeth of a short-term volatility storm, right? Right?

Well … apparently that’s not right. And to explain why, we have to go back to this statement – the market price of your portfolio of promises to repay you more money in the future goes down if interest rates go up, and the market price goes up if interest rates go down – but we have to look at it from the perspective of the pensioners, not the pension. Or rather, we have to look at it from the perspective of the promises that the pension has made to the pensioners, a promise to repay the pensioners in the future with more money than the pensioners are giving the pension today. This collection of promises to repay pensioners in the future (called a pension “liability”) works by exactly the same math as any other promise to repay money in the future: when interest rates go up that pension liability goes down, and when interest rates go down that pension liability goes up.

Okay, but I still don’t see the problem, Ben. If interest rates went up sharply, then that means that pension liabilities went down sharply. Why isn’t that a good thing?

The problem is that interest rates have been going down for 30 years, and really going down for the past 15 years. Which means that, from this accounting perspective, pension fund liabilities have been going up for 30 years, and really going up for the past 15 years.

The problem is that every quarter, pension fund managers must go to their board of directors and tell them the ratio of assets to liabilities. If there are fewer assets than liabilities, that’s called being “underfunded”, and your board of directors hates that. But if you can show your board that you are less underfunded today than you were last year, you get a nice pat on the shoulder and maybe a bonus or a raise. On the other hand, if you are consistently more underfunded today than you were last year … the board will fire you. Not the first year where you’re more underfunded, and maybe not the second year either. But more than that? Yeah, they will fire you. They will tell you how much they love you and what a great job you’ve done in soooo many respects, but they will fire you. Being more or less underfunded over time is how pension fund boards track wins and losses. It’s like being the football coach at a big university. You can have one losing season and maybe you can have two. But more than that and you’re gone.

So you can understand that seeing your liabilities go up quarter after quarter, year after year as interest rates go down quarter after quarter, year after year is a real drag (literally and figuratively) for pension fund managers. Luckily, Wall Street – in the form of UK pension consultants – was ready with a solution!

Remember how I said that Wall Street has two and only two jobs, to invent new ways to securitize something or new ways to apply leverage to something? Well, in this case it’s the invention of a new way to apply leverage to the problem of liabilities going up when interest rates go down, and it goes by the name of “Liability-Driven Investment” or LDI.

Quite literally, LDI is a hedge fund strategy. It is a strategy to hedge your liabilities by investing in a way that should make money and offset whatever is making your liabilities go up, which is interest rates going down. Specifically in the case of UK pension funds, it is an investment program that uses leverage – borrowed money – to bet on interest rates continuing to go down. The idea is that every dollar you make from this bet will offset a dollar increase in your liabilities, and that every dollar you lose from this bet will be offset by a dollar decrease in your liabilities. It is a pure bet (called an “interest rate swap”), where every day there is a winner and a loser. It doesn’t cost you much cash money to set up, maybe 10% of the total amount that you’re betting on (your 10% earnest money is called “initial margin” and the total amount that you’re betting on is called the ”notional” of the swap), and you can use the other 90% of the amount you’re betting on – money that you would otherwise have used to buy 100% of the asset – to make other investments. That other 90% is leverage.

Now here’s the kicker. The pension consultant team can prove to you that this is reward without risk. They can prove this because they can show you the past thirty years of betting performance with this interest rate swap, how you always end up ahead by investing in something else with that leverage, how the risk of something going wrong is vanishingly small because the volatility of that interest rate swap has been really low over that entire span of time. Sure, there was a little spike in 2013 with the so-called “taper tantrum”, but nothing you couldn’t handle. They will speak to you about “VAR” and “99% confidence levels”, and you will believe them because the math is correct and who are you to argue with math?

And then the math broke.

And then interest rates went sky-high as the Fed hiked a lot and the Bank of England didn’t, racing higher in a way that hadn’t been seen in the past 30 years.

And then the next morning, the bank on the other side of the bet emailed you to say that you owe them a lot of money because UK interest rates are going sky-high. And you only have until that afternoon to pay in full. In cash. This is a “margin call”. But you don’t have a lot of cash sitting around, so you have to sell some other assets – almost certainly government bonds – to get enough cash together to pay off your bet with the bank. You get a terrible price on the bonds you sell, because their value has gone down as interest rates have gone up. The terrible price gets more and more terrible as the day goes on, as everyone smells the blood in the water. But you survive. You take a gruesome loss on the bonds you had to sell, but you survive.

And then interest rates went sky-higher as Truss and Kwarteng unveiled their goofy plan, racing up in a way that hadn’t been seen … ever.

And then the next morning, the bank on the other side of the bet emails you to say that you owe them a LOT more money because UK interest rates are going even sky-higher. And you only have until that afternoon to pay in full. In cash. But now you have zero cash, so you have to sell a LOT of government bonds to cover that margin call. But yesterday’s terrible price of those bonds is … wait … this can’t be right. This price is impossible. There are no buyers for these bonds. None. No bid. You’re not going to be able to make the margin call to the bank on the other side of the bet. Which means that you are … ruined. All of the pension assets are now forfeit, because that’s what happens when you can’t make a margin call. The bank will sell your assets at whatever fire sale price they can get. Because that’s what banks DO.

Congratulations, you turned a long-term investor into a freakin’ hedge fund, and a miserably managed one at that. You killed your pension fund. But hey, your liabilities that will be due in …[[checks notes]] … twenty freakin’ years went down! LOL.

So the chairman of your board makes a call to a buddy at the Bank of England. They’ve known each other since they were in school together. And this isn’t the first call that his buddy has gotten that morning. This is happening to every pension fund in the country. This is a Lehman moment.

So the Bank of England does exactly what they have to do, what they were created to do (other than shape the price of leverage). They become the buyer of last resort. They pledge infinite money – tens of billions of pounds if required – to buy those UK government bonds that no one else wants to buy and the pension funds have to sell. They bail the pension funds out. And the banks to whom they owed the bet! Because that’s what central banks DO.

BTW, this last point doesn’t get nearly enough attention. When a government bails out a gambling debt that a big asset owner suffers against a big bank – like when AIG lost tens of billions of dollars in a big bet in 2008 with Goldman Sachs, and the US government paid off that debt – they’re not just bailing out the asset manager, they’re also bailing out the bank.

Anyhoo, since that happened last week, the pound has stabilized. Gilts have stabilized. Everything has stabilized. Whew! Lehman moment averted. Lesson learned. Glad that’s over!

Except that it’s not.

It will take years to unwind these LDI programs, if they ever are, in fact, unwound. The consultants are hard at work, I’m sure, reassuring everyone that this can’t possibly happen again. More fundamentally, every UK pension fund has taken a series of body blows here. Every UK pension fund has a couple of broken ribs and I’d be surprised if there’s not internal organ damage for some. It always takes a couple of months for the final casualties of these moments to reveal themselves, much less if there’s another shock.

And what about the US? Could the same thing happen here? Why didn’t it happen here, minus the Truss/Kwarteng insanity? Luckily, the US pension fund world is not quite as reliant on the pure bet method of LDI as the UK pension fund world. There are securities available to US pension funds, like Treasury “strips” where you’re just buying the interest rate promise and not the entire bond, that US pension funds can purchase without leverage in order to accomplish LDI goals without using interest rate swaps.

But the real problem isn’t that UK pension funds used interest rate swaps rather than some other, slightly less dangerous Wall Street securitization/leverage concoction.

The real problem is that every pension fund in the world has implemented some sort of Wall Street securitization/leverage concoction, intentionally designed to make the managers look good in their quarterly reviews, intentionally designed to use short-term leverage against long-term obligations, intentionally designed to use the math of the past thirty years to obfuscate the risks of a regime change not found in the past thirty years.

Wall Street has infected some pension funds a lot with their words of riskless return through the magic of securitization and leverage. Wall Street has infected some pension funds a little with their words of riskless return through the magic of securitization and leverage. But Wall Street has infected ALL pension funds.

Because that’s what Wall Street DOES.

I have no idea where the next Truss/Kwarteng insanity will come from.

All I know is that leverage is being repriced, globally.

All I know is that this global repricing of leverage is a wrecking ball around the world, through both interest rates and currencies.

All I know is that what we saw happen in the UK last week is the first shock, not the last, and all the massive pension funds and asset owners who have turned themselves into shadow hedge funds, full of swaps and leverage through the sweet whispers of Wall Street Wormtongue, will be our undoing.

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  1. Avatar for xmj xmj says:

    Great stuff - and here’s a request for a sequel note on the effects of the undoing of the decades-long artificially suppressed interest rates – on global supply chains, globally organized conglomerates, and last but not least, the freedom of movement.

    If you’re already knee-deep wading in Austrian waters, might also go the roundabout way into the production theory and its relation to time preference, that underpins everything of the current global organization of the production and shipping of intermediary and consumption goods.

  2. Avatar for 010101 010101 says:

    The UK has a special kind of pension system that is not clearly demarcated in the common knowledge spectrum. Public sector employees have been granted (by themselves) defined benefit pensions (defined liability to issuer [treasury]) in contrast to private sector employees who have to bear the slings and arrows of outrageous fortune (defined contribution schemes [no legal liability to issuer other than, ahem, diligence]), except the scale of the government richly defined benefits has set the pace and expectations of all pensions because well it has to be fair and equal and all that. Everyone has become certain that all pensions always pay out except sometimes in the quiet backwaters of private industry when a corporate pension scheme falls of its yacht.

    Is it worth mentioning how ridiculous it is that the blame goes no further than the fund manager rung, or how actual macro monetary risk is distorted by hate focused blame from a public who have almost no control of the lens?

  3. First of all - the note is really good. I do appreciate when someone with a lot of knowledge goes through the trouble of making something super complicated - less so!

    As I read I only made a couple of mental notes, in no particular order of importance:

    • even for cynic, it is perhaps not super useful to define government on only a singular dimension- as “the people with a local monopoly on the legitimate use of violence”. It’s not that it is not correct, perhaps I just think it is not a very useful simplification at this particular point in history where populism is on the rise everywhere and democracy is facing serious challenges… It will be a popular take though, so perhaps it is worth it.

    • perhaps in a similar vein, to let the equation of “the rich” with “job creators” stand unchallenged, is also perhaps not ideal at this point in time - as “trickle down economics” is having a tough old time these days.

    Primarily, reading your note (and your recent tweets about ZIRP etc) has me thinking of a recent book review I read in the Financial Times. I tried to post the link but I believe there is a paywall.

    It is an article by Martin Wolfe, writing about a new-ish book called “The Price of Time” by Edward Chancellor. A friend of mine (at a UK investment house called Ruffer) recently sent me a copy and I guess I was trying to figure out if it was going to be worth my time reading it… As it happens, I very much suspect that you and Edward Chancellor agree on the world at large, as his main assertion is the the price of money and therefore time has been far too low, for far too long.

    So, in summary - I really enjoyed the article. And if I got to wish for a follow up note it would be one that goes deeper into the “time preference of money” topic. I find this subject really interesting as it is yet another area of economics that exists very close to philosophy and is therefore probably also closely related to the power of narrative.

  4. Avatar for bhunt bhunt says:

    I forgot to insert my [sarc] notation on that one, Em! I think the whole “job creators” word play on tax cuts is absolute bollocks.

  5. Pensions are similarly skewed in the US. The private sector has nearly no defined benefit plans anymore, other than in companies that have been around 50+ years. The public sector historically paid less in direct compensation but offered much more generous defined benefit pensions. As defined benefit plans disappeared for private sector workers they continued to flourish for public employees. And, the impossible 7-8% return promises in a world of high valuation and minuscule interest rates has led to all manner of behaviors that also involve consultants and hidden leverage. The massive shift to private equity and private credit has the money flow from public pensions as the motive force.

  6. Avatar for jewing jewing says:

    Johannes is correct: any close reading of this note ends with the question of “How did we get here, and why?” And while many of us here have our suspicions, and they are likely pretty similar - central banks choosing to inflate assets, and keep them inflated, to avoid political consequences - it certainly warrants further exegesis.

    And of course, “Against the Gods” by Peter Bernstein should be required reading for anyone looking to further understand the history of leverage.

  7. I hope the note breaks through due to how well it lays out the issues and walks the reader along the path to where we are. I fear that investors still aren’t internalizing the cost and risks from putting interest rates back to a level that nominally covers inflation.

    I attended a dinner with five other couples in my peer group. White collar, upper middle-income, empty nesters. All now have children trying to join the homeowner’s club as they start careers and families. The overwhelming sentiment remains 6.5% mortgages are sooo reasonable! Lots of anecdotes of each couple’s first mortgage cost (all between 9% and 14%). None are connecting the dots that they were financing $100k @10% ($878 monthly for a 30 year loan). In neighborhoods with schools they want their grandchildren attending, their kids need to borrow $600k, and cobble $150-200k in a down payment! That is a $3792 per month. Worse, the house price moved up $50k from when junior started looking and got prequalified for a 3% mortgage. So, they budgeted $2319 (3% on $550k) and the market has completely moved beyond their budget. Our generation got the benefit of the value change as rates fell. Our kids face paying record valuation and not having persistent refi cycles to build or extract equity.

    There are substantial risks to the market clearing, and a loss of equity when home prices fall 10-20% and a job related move becomes necessary. Similarly, institutional investors are deer in the headlights to the simple math of higher cap rates impairing any deal structure with leverage done in the last decade.

  8. is absolute bollocks.

    I see what you did there :wink:

    Great note Ben , I might add that in addition to all these pensions turned hedge funds are the hedge funds themselves and some of them are on the wrong side of all this volatility. I think the global estimate for derivatives is 1 QUADRILLION dollars.

  9. Avatar for 010101 010101 says:

    That is how biased and naive I am to believe in somewhere that is not twisted out of shape by neo-Keynesian legerdemain. Does Europe have them also?

  10. Avatar for xmj xmj says:

    On the note of deer in the headlines, I came across a pretty solid article from Bloomberg published yesterday:
    European Real Estate’s Decade-Long Party Is Coming to an End – likely paywalled, archive.ph might help here…

    A place where you can already see the transmission mechanism between higher interest rates and lower asset prices: real estate companies. So much so that Vonovia SE, biggest corporate landlord of flats in Germany, finds its stock is two thirds off the highs from Q3/2020 – and that’s before having to write off significant amounts of Euros on those assets it does retain (i.e, cannot offload fast enough).

  11. Avatar for xmj xmj says:

    That was indeed a great book (he also couldn’t hide his closet-Austrian viewpoints) and I second thinking @bhunt & Edward Chancellor agree in more ways than not.

    Now has me wondering if we could bait them into doing a podcast together on all this.

  12. Avatar for 010101 010101 says:

    In the book of Matthew chapter 20 unskilled manual labor costs 1 Denarius (about 4 grams of silver) or about $2.57 per day.

    Who says trickle-down economics is gammy!

  13. This gets at something I was pushing a week or so ago in another thread.

    FX is a relative game. Anything the Fed is doing will be felt by the rest of the world, and what economies will be strong enough to allow their CBs to keep up with the Fed in terms of hikes and tightening? The PBOC is loosening which is why the USD continues to annihilate CNY. The ECB has been functionally allergic to rate hikes until very recently and they’re still considerably lower than the US. Hell, until like an hour ago they were still living in the land of ZIRP and in some cases negative rates. They’re not even at 100bps yet!

    The only way the USD weakens dramatically is if there’s a very hard landing that forces the Fed to ease at a pace and degree that is more dovish than any of their contemporaries. I’m failing to imagine a scenario in which that happens. If nothing else you can always depend on the Europeans to be more dovish than the Fed.

    One of the many layers to this tiramisu of global misery is the US is not only exporting inflation via the USD going full Tasmanian Devil, but the situation will simply not abate until the Fed slows down while other sovereign CBs continue to hike. If tomorrow every CB agreed to cease any further hikes the USD would continue to maul local currencies because in a relative sense nothing will have changed.

  14. Avatar for KCP KCP says:

    Great insight - thanks - did not know about this new hedging “tool”. It seems that every time (increasing with frequency) that these credit bubbles explode, the plumbing of the system gets exposed. That is, the water only really flows one way and when the “modeling” of the product is exposed to unanticipated factors. The water backs up, leaks through the seals/fittings of the pipes and may result in a flood.

    Then, as Ben points, out, the mess gets cleaned up through some bridge (Govt/Central Bank intervention) and the world moves on with the same leverage and new “tools” and “models” to seemingly avert the next crisis.

    One would think at some point, this has to stop. This is above my paygrade/intellect, but doesn’t some entity bear the cost when our modern day “Saviors” (Govt/Central Bank) come in to clean up the mess? Isn’t that someone the taxbase of a nation?

    We clearly live in credit cycles and it seems that some of the pain just gets kicked down the road for future stakeholders to deal with…I hate to be pessimistic here but does it seem unrealistic to see the Fed in the US step in the minute that delinquencies start rising in the lower credit quadrant of car loans, in order to make the delinquency “go away” in order to prevent a panic?

  15. Avatar for 010101 010101 says:

    The policy committee are looking at “aggregate demand” which is way more ephemeral than solely the credit of “those recently without a car”.

  16. Hi @bhunt,
    Having spent a week or so reading and watching and reading and watching…
    and with everything that ET has brought to the table about the value/power of narrative over everything else in mind, an important question has now taken residence in my admittedly exasperated mind:

    What is to stop (if anything) the following narrative from taking hold in the world-at-large:

    - Raising rates was the policy error.

    (rather than the more factual assessment, that artificially low interest rates caused all of this)

    I am not looking for a discussion about which narrative is right (I am all in on your side already), but I am also starting to realise a few things about Derek J de Solla Price’s concept of “embedded growth obligations” and the demographic challenge cause by scientific progress’ exponential curve…

    And if low rates is viewed as a more “practical” solution, than the list of more dramatic potential policies - can this narrative be stopped?


  17. Avatar for bhunt bhunt says:

    Great question, Em, and right now the narrative is moving in the direction of “yes, we understand we need to raise rates, but we don’t need to raise them so quickly.”

    Like many things, it’s hard for narratives to make a complete state-change quantum leap to “raising rates was the policy error”. We’ll go through variations of critique (timing, extent, duration) before we get to 180 degrees different.

  18. I’m curious how Japan plays into all of this. Seems like the carry trade might have some major ramifications for the world while the Japanese Central Bank is still trying to manipulate their economy with low interest rates/currency. The UK is probably just the beginning but it could also mean the Central Banks will have to continue with their ploy.

  19. Mohamed El-Erian, a key missionary in the Fed/central banks orbit, raised a related issue a few months ago. He warned against a start/stop dynamic where the Fed loses its nerve to maintain restraint until inflation is back to target. It is pretty clear Powell got the message! But, the unwinding leverage would, and likely will, push the financial stability mandate back into first priority as we’ve seen at the Bank of England. The shape of the yield curve is a reflection of the market pricing the risk of a related break in market function in US markets before the Fed gets to its forecast terminal rate. So, we are left to ponder what happens when the central banks are blamed for the error of raising rates and the financial carnage that is unleashed? And, with inflation still extant. Seems that will be when credibility/missionary status starts its inevitable decline.

  20. “falls off its yacht.”
    Ha! I see what you did there. Looters gonna loot, I guess.
    Thanks for the details - step-daughter’s b/f works for NHS; I presume his is of the (treasury) variety.

  21. Avatar for alpha2 alpha2 says:

    Here in Blighty no end of terms are redefined. Today I heard a Labour politician defining public sector workers, in the context of NHS Nurses balloting for strike action, as “the real wealth creators”. Who they were being contrasted with was not made clear. Perhaps she was referring to social wealth.

  22. Avatar for Trey Trey says:

    Same story different day.

    Step 1. Securitize pennies in front of a steamroller
    Step 2. Sell the shit out of it till it’s too big to fail
    Step 3. Profit
    Step 4 Repeat

    Where was the bailout when those assholes sold XIV to retail investors?

  23. Thanks, I do think it is early for the shift in narrative - but that it will come.

    Probably when the US treasury market has its own “moment” and it will start when this moment is tied to something non-bank/financial elite that the public at large will not want “broken” in the name of higher interest rates. Pensions was a good one here in the UK, but anything in the vicinity of “real people” will do.

    It feels like the scene is set for something already, with Waller’s recent statement…which I guess is “credibility-building” exercise for the Fed - who probably doesn’t want the neon sign “buyer of last resort” flashing on their door prematurely, and certainly not in service of the international community as opposed to domestic markets. Considering the nature of the US treasury market, this distinction is of course artificial…

    Do you still use Quid for your narrative analysis? If so, how much of the output would you say is influenced by the early search parameters/questions? I guess I am wondering about how much the narrative analysis is influenced by any one user’s early focus?

  24. On point. I’m down here in Australia and that is exactly what is happening. We’ve have to keep pace whether we need to or not. The other thing worth noting is that the pseudo positive in cheaper goods presumes that there are no trade restrictions in place. In OZ there are many.

  25. Ben is right – this is less about the UK and more about the fabric of the global financial system. The frequency of major margin calls had already been rising, and will continue to do so. Who’s next?

  26. First, my compliments to Ben and his team as well as his readers. I’m always challenged to “keep up”. Thank you.

    In my mind, an unravelling is occurring of leverage that is long overdue.

    How will it play out? Can the Fed contain it? Will it get too big to contain?

    The Uk bank is practicing QE and higher rates at the same time the government proposes an expansonary budget. Unfortunately the yard is greater than the sandbox and the yard forces equilibrium.

    The UK scenario sounds a lot like the prospects of the U.S. e.i. The Fed fighting the fiscal powers and likely to have to provide liquidity.

    Are we a sandbox in the U.S. or the yard? We could be the yard, being the reserve currency. I think a sandbox, though.

    So what is the yard? Global leverage? The money multiplier? Faith?

    Ben suggests he doesn’t know the next Truss/Kwarteng, but I bet he can guess!

    My guess is the Fed loses control of interest rates and we find we are not rich anymore. I think the “Least Dirty Laundry” arguement for currency only works in stable finance or the short term.


  27. Avatar for josh josh says:

    Hi Ben,

    Thanks for a great note as always. But what do you make of the argument by proponents of LDI that their approach is a prudent strategy for reducing risk given the massive long-dated liabilities of these plans? To play devil’s advocate, the present value of these liabilities is not just an accounting quirk but a genuine reflection of the plan’s net economics. This reduction in risk is aside from any potential advantages from the the expected return of buying duration. Granted, the current crisis has shown the hazards of posting margin on these trades without any offsetting cashflows from the reduction in plan liabilities (a risk that was clear and present at least since the Metallgesellschaft debacle). But that is probably a question structure and implementation, while you cast the entire enterprise in a very negative light. For what it’s worth, it seems from a recent JP Morgan analysis that UK pensions have seen their liabilities fall more that their assets in the recent volatility (admittedly with massive government intervention). I’m interested to hear your thoughts.

  28. “If you have a pot of money that is immune to bank runs, over time, modern finance will find a way to make it vulnerable to bank runs. That is an emergent property of modern finance. No one sits down and says “let’s make pension funds vulnerable to bank runs!” Finance, as an abstract entity, just sort of does that on its own.”

    -Matt Levine

    Seems to be the Cliff’s Notes version of what Ben covered in great detail.

  29. Avatar for bhunt bhunt says:

    Yes, I am presenting the entire enterprise of pension funds borrowing short to lend long in a very negative light because it is - in my opinion - an enterprise of complete and utter bullshit.

  30. After reading this note again last night, decided to go back and refresh my memory from the GFC. Chart is S&P 500 from 2007-2009 with events highlighted. Its surreal looking back at the enormity of it all, cascading effects of leverage being unwound week after week after week over 18 months. Not that 2022 will follow the GFC, but interesting to see how the dominoes fell, and how my memory had compressed it.

    Maybe history does rhyme though, when you see that first headline in late 2007…
    “BOE makes emergency loan to Northern Rock”.

  31. Avatar for bhunt bhunt says:

    I remember Northern Rock!

  32. I was managing a long/short fund through 2008/9. None of my memories of that period are good, even though I managed to eke out a positive return for our investors. The trading was nearly impossible as liquidity was withdrawn. Crisis driven proposals were hurled into the chasm, and investors believed that each policy would save the system… until enough time passed to reveal that confidence as misplaced. The epicenter of the financial loss was in the banks and here is the S&P Bank ETF chart from 2008.


    Along the path of destruction there were several headlines that resulted in this index rocketing 20-40% higher on its trip from $50 to under $10. I vividly remember many mornings when my short financial positions were indicated up 30-50% in pre-market indications. First, sovereign wealth funds were confidently adding to positions and proving extra capital. Then, bans on selling financial stocks short, then all manner of government backstops, and finally just rip up the rules of bankruptcy (GM) and bank accounting (mark to market). It became crystal clear over the journey that the fundamentals were so bad that they could not be allowed to unfold. Seeing the levers pulled defied any description of free market capitalism.

  33. Avatar for bhunt bhunt says:

    This was my experience, as well.

  34. 2008 October was truly bad.

    I recall looking at whiteboards where the bank’s senior treasury officials would update traders on $ liquidity availability.

    In most cases it was max 30 days only available through the broker market.

    When you get a question from a junior trader whether they should execute a trade with a major US investment bank because rumours are that the collateral quality offered had become so poor, just fired up the anxiety levels even more.

    There were a few days in October where it truly felt like the plumbing of the financial system would fall apart.

    Then it all turned.

    Even though prices continued to fall until March 2009, the plumbing started to work again. Repos started to work again meaning liquidity returned.

    The issue with pension funds has always been a maturity mismatch and as a derivative house.
    I recall even in the early 90’s, swaps were designed to feed this gap. In those days banks posted collateral. Larger funds didn’t. And derivatives had to be structured not to be deemed to be derivatives.

    As Ben so eloquently explained, in recent times, the margin posted to UK pension funds on LDI swaps as rates fell, were used to buy assets instead of being held in their collateral account.

    Managers like Blackrock showed you models suggesting rates would not go higher than say 1.25%. The excess collateral could be used to buy less liquid private assets which coincidentally the likes of Blackrock have an inventory of :innocent:.

    From 2007 till recently, central banks added so much liquidity but also changed the rules on capital markets making it so difficult for banks to hold or trade risk assets. Many trading desks have shut down. Many senior traders left. There is less market making which means that price moves are so much more volatile.

    After 14 years of ample liquidity we are seeing the effect of deleveraging of a hyper leveraged market in a market filled with players who are inexperienced and only seen a bull market.

    Now rates have turned and how? And we have an almighty mess on our hands.

  35. I wrote a blog on that probably around 2009. The rules weren’t ripped up. The senior secured was preserved - PBGC which was a subsidiary of China Inc. at the time buying all the UST. Indiana’s AG sued on behalf of the state pension because he didn’t realize that owning GM IG debt put you at the bottom below stock holders given that bankruptcy would have forced GM’s way underfunded pension into PBGC responsibility which would have required massive Treasury issuance, risk cascading of other underfunded pensions, etc. That’s rich given that Indiana failed to police Studebaker embezzling their pension which led to the creation of the PBGC. So the subordinated IG debt was taken out. It’s extraordinary to me how few understood this that needed to.

  36. A few years ago, at a conference for CFPs - tend to focus more on consequences to individual than collective and wade farther into philosophy - a speaker pointed out that human history was about to cross a new line with unknown consequences. When the US instituted social security the average length of benefit payments was less than two years. As similar welfare programs and corporate pensions were instituted globally the average length of payout was less than a decade in most cases.

    In at least the developed world with retirement savings and longer life expectancy, humanity was just about to cross the line to more years as adults in retirement than working. This of course is on average. The presenter hypothesized this would lead towards great opportunities to advance society as more than half of those working would have the time and capacity to gain more knowledge or pursue new opportunities, dreams, or advancements.

    The first order reason for money was to reduce friction in exchange of economic utility. About a nanosecond after that someone with the ability to, realized that they could save some of this utility for future use as opposed to the complication of the man in Luke 12. All similar to what Ben wrote.

    And now more than 50% of us in the developed world expect to store enough future utility by some vehicle in a shorter amount of time than we expect to draw from it by tearing down our barns and building bigger ones. But God called this rich man a fool. And having to maintain barns filled with stored grain is too much work compared to having a bank account, or pension. And Wall Street loves to separate fools from their money - which is what Ben calls securitization. Or just front running what would happen to that man’s stored utility when he dies.

  37. The plan that allowed GM to get to the other side hinged on ten’s of billions of taxpayer support. That was just one of the “too big to fail” situations we faced by allowing prior gains to be privatized and eventual losses to be socialized. GM creditors did not face the music of letting managment operate as a refi lender instead of running a focused and profitable car business. The fact that the taxpayer had to step in was the blurring of the rule of law that I was referring to.

  38. UST Liquidity: Cloudy Skies

    This report was in my email this morning.

  39. The Long end of the Treasury market does not appear to be functioning rationally.

  40. The handoff of trading from Europe to the US felt like it had bond margin calls and derivatives driving the price action. Currencies, bonds and stock futures were all over the map! The Yen neared 152 vs the dollar, the US 10 yr approached 4.33% (it was under 4.00% on Tuesday), and equity futures were under water. Then, the dollar reversed and the curve flattened a ton. Yen now back under 147! Euro and pound also now up on the session. Treasury yields 10 basis points lower than the morning peak, stock futures reversed to up. Reports that Yen “knock in” trades are giving it a bid once it reversed back below 150. And, of course fears of intervention by the BOJ since they did that around 145 to no effect a few weeks ago.

    It is not “normal” for the UST to move in 25-30 basis point increments over a few days with no proximate economic data as a piece of new market information. This is urgent flow and urgency is created by leverage.

  41. Avatar for bhunt bhunt says:

    100%. If you don’t see that the plumbing is broken, you’re not paying attention.

  42. The 5 year UST is 10 basis points lower and the 30 year yield is 10 basis points higher.
    “Flattened a ton” is the perfect description.

  43. Avatar for twclix twclix says:

    In 1995, I co-authored a book entitled: Pension Funds: A Common Sense Guide to a Common Goal. It was soundly panned by P&I who called us naive and worse. At the time, the defined benefit plans we spoke with were not at all interested in our re-invention of liability-driven investing. By re-invention, I should note that railroad pensions were managed solely with unleveraged bonds. But that practice came to a halt with the advent of modern portfolio theory where minimizing cross-correlation volatility and beating a peer benchmark became more important than paying all the pensions affordably and without fail.

    Our LDI premise was simple–the purpose of a DB pension fund is to pay pensions–without fail to the plan participants and affordably to the contributors. We recommended defeasing the near-term (5years? 10 years? Just how lucky are you feeling today, punk?) liabilities with money-good fixed income (no leverage), with a cash matching or duration matching strategy.

    The length of the defeasing period would reflect how much risk the board was willing to take. With ever-lower interest rates, defeasing was expensive (prudent and expensive, that is), so the board would have to be judicious. The real trick was to pay close attention to match the term structure of the liabilities (short-term, medium-term, and long term–pension funds have obligations from today until the last plan participant dies so they are NOT only long-term investors).

    The plan would establish a hurdle rate that, when exceeded by returns on the assets in the non-defeased component of the portfolio, could trigger harvesting to fill in the most distant liability cells of defeasement with more money-good bonds to stay on a targeted funded ratio path. This is really an elegant solution that did not rely on the narrative embedded in modern portfolio theory.

    MPT is a tool, like a screwdriver or a hammer. But it is a flawed tool because it has no way to account for the payment of a specific set of obligations at specific points in time. It is based on probability theory which assumes time constancy where the past is sure to be prologue.

    So nobody cared and we had to write another book (Pay Yourself First: A Commonsense Guide to Life cycle Retirement Investing) and launch the first target date mutual funds and pay the SEC $600k for a no-action letter for the priviledge of doing so!! But that’s another story.

    Nobody cared, that is, until the consulting community got cute and added leverage to the strategy, and the whole thing then went cockeyed. P&I, so quick to call us idiots, began holding conferences on leveraged LDI. Yikes!

    But our simple approach was (and still is) the best way to achieve an maintain a targeted funded ratio. But it was far too commonsense and boring until Wall Street came in with their derivatives.

    There’s a lesson to this tale, I suppose. But hell if I know what it is.

  44. Avatar for bhunt bhunt says:

    What a great letter! Thank you, Timothy!

  45. Avatar for 010101 010101 says:

    That is really quite a beautiful anecdote about human nature.

    A man avails himself of the truth so long as it is serviceable; but he seizes on what is false with a passionate eloquence as soon as he can make a momentary use of it; whether it be to dazzle others with it as a kind of half-truth, or to employ it as a stopgap for effecting an apparent union between things that have been disjointed.

    And I would add, when over time a newer truth becomes undeniable, he professes to it having been his opinion all along.

  46. Sorry I thought you were addressing the common argument that allowing equity ownership to maintain some value while debt holders were forced to take a markdown violated law. And sure, it violated the letter of the law. But if you look through the entities and account for where the largest senior preferred liability stood, which was the underfunded pension, then the situation is more reasonable. That’s opposed to bailing out AIG so they could write a big check to Goldman Sachs who clearly negotiated in bad faith.

  47. Back in 2020 our dealerships entered an interest rate swap to make our floor plan borrowing fixed at perhaps 50 bps above libor at the time through end of 2024. I was stunned anyone could think the current actions of policymakers would not explode inflation. And I had no belief we could get to, let alone sustain negative interest rates. It took a few weeks to even get set up to execute the swap because the bank’s swap desk was so flooded with activity. I thought, “who on earth is taking the other side of this bet? Are those people crazy?” I guess you’ve told me who thinks betting on sustained low rates was a good idea. And my swap is hugely in the money, meaning in the zero sum game of Wall Street I am a recipient of the folly of this approach pension funds took.

  48. I have PTSD when I read that chart.

  49. US government is giving $36 billion to shore up the Central States Pension Fund.

    “Why am I reading this now?” Is it just a part of the averted rail strike? Or is the insolvency of the pension fund becoming a lack of liquidity?

    Curious what the pack thinks.

  50. Central States Pension Fund was set up to benefit Teamsters in the trucking industry. It has been technically insolvent and in need of rescue for more than a decade. If it was not shored up it would have resulted in a need for liquidity at the PBGC. It seems the American Rescue Plan passed in 2021 is being used to fund the gaping hole.

  51. Shocking that in the Long Now, with returns in stocks and bonds pulled decades forward , then pension still found itself insolvent.

    The precedent is set , yet another function of Govt.

  52. So if a decade long bull market and extremely low inflation still wasn’t enough to bail out that particular pension fund you have to ask yourself who’s been getting rich running what then is effectively a Ponzi scheme for all these years. Right?

  53. I have to say I don’t know the particulars of what ran this particular asset base aground. But, the common themes of the ones that have needed bailouts over years involve industries in secular decline or industries that deregulated with prior union constituents. Think steel, airlines, trucking, coal, autos. I bet when trucking was a heavily regulated industry it earned excess profits that the union was able to reap a strong share of. Deregulation happens, prior promises become difficult to keep, membership falls and sustaining the contributions is the responsibility of a smaller work force.

    These promises were part of a defined benefit promise and those promises were not always just a simple promised cagr of 8% or now 7-7.5% on an actuarial last 3 year average salary. I used to manage pension assets of public workers like firefighters, police, and city employees. The model was to pay these workers modestly but give them generous pensions. There were lots of ways the system could be gamed to assure that the employee got the maximum amount of shifts and overtime in the years that were setting their pension benefit for life. This is how employees who may have never earned a six figure salary over the entirety of their employment history sails into retirement with a guaranteed $100-150k per year pension. Perversely, the years of great returns made offering these gold plated perks seem riskless.

    So, the underfunding is a combination of sometimes overgenerous promises, companies or entities trying to minimize their annual contribution (or back in the days of glorious returns they would brazenly raid the overfunded pension as a hidden asset), and difficulty compounding large sums at 8% while withdrawals are happening. Pension boards are just as human as other investors and they typically have too much risk at cycle peaks and shed that risk into cycle troughs.

    And, of course the consultants, actuaries, advisors, and managers made their fees even if the fund didn’t measure up in the end.

  54. *I did a simple search for “raiding overfunded pension” and found a book written by a Wall Street Journal investigative reporter in 2011. Wall St Journal, not ProPublica! The relevant reference is so old because it has been a long time since there were hundreds of overfunded pensions to raid.

    This also struck me as an example Ben might use like his father’s hospital being sold while he got downsized. Thousands of employees lost jobs and their pensions ended up as wards of the PBGC while top management walked away centi-millionaires.

    The book is "Retirement Heist: How Companies Plunder and Profit from the Nest Eggs of American Workers". Here is the Amazon review of the book and it reminded me that this strategy was a key Jack Welch innovation at GE that made quarterly earnings management so much easier.

    “‘As far as I can determine there is only one solution [to the CEO’s demand to save more money]’, the HR representative wrote to her superiors. ‘That would be the death of all existing retirees.’”

    It’s no secret that hundreds of companies have been slashing pensions and health coverage earned by millions of retirees. Employers blame an aging workforce, stock market losses, and spiraling costs- what they call “a perfect storm” of external forces that has forced them to take drastic measures.

    But this so-called retirement crisis is no accident. Ellen E. Schultz, award-winning investigative reporter for the Wall Street Journal, reveals how large companies and the retirement industry-benefits consultants, insurance companies, and banks-have all played a huge and hidden role in the death spiral of American pensions and benefits.
    A little over a decade ago, most companies had more than enough set aside to pay the benefits earned by two generations of workers, no matter how long they lived. But by exploiting loopholes, ambiguous regulations, and new accounting rules, companies essentially turned their pension plans into piggy banks, tax shelters, and profit centers.

    Drawing on original analysis of company data, government filings, internal corporate documents, and confidential memos, Schultz uncovers decades of widespread deception during which employers have exaggerated their retiree burdens while lobbying for government handouts, secretly cutting pensions, tricking employees, and misleading shareholders. She reveals how companies:

    • Siphon billions of dollars from their pension plans to finance downsizings and sell the assets in merger deals
    • Overstate the burden of rank-and-file retiree obligations to justify benefits cuts while simultaneously using the savings to inflate executive pay and pensions
    • Hide their growing executive pension liabilities, which at some companies now exceed the liabilities for the regular pension plans
    • Purchase billions of dollars of life insurance on workers and use the policies as informal executive pension funds. When the insured workers and retirees die, the company collects tax-free death benefits
    • Preemptively sue retirees after cutting retiree health benefits and use other legal strategies to erode their legal protections.

    Though the focus is on large companies-which drive the legislative agenda-the same games are being played at smaller companies, non-profits, public pensions plans and retirement systems overseas. Nor is this a partisan issue: employees of all political persuasions and income levels-from managers to miners, pro- football players to pilots-have been slammed.

    Retirement Heist is a scathing and urgent expose of one of the most critical and least understood crises of our time.

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