A personal view from Ian Stewart, Deloitte’s Chief Economist in the UK. To subscribe and/or view previous editions just google “Deloitte Monday Briefing”.

Last week’s action by the Bank of England to support UK government bonds, or gilts, was its biggest intervention in financial markets since the pandemic. Action was needed to prevent a sell-off in gilts developing into a wave of contract defaults across UK pension funds. The FT, citing City sources, claimed the UK had come close to a Lehman-Brothers like financial collapse.

An arcane part of the financial plumbing of the UK economy, liability driven investment (LDI), was at the heart of the crisis. LDI uses derivatives to match the cost of future pension pay-outs with the value of the pension fund’s assets. The linkages are complex, but the sell-off in 30-year UK gilts forced pension funds to sell down their own holdings of gilts to cover costs associated with LDI strategies. That reinforced the gilt sell-off, threatening a downward spiral of plummeting gilt prices.

Without the Bank’s pledge last Wednesday to buy gilts on “whatever scale is necessary”, the sell-off could have turned into a financial crisis. The episode illustrates how financial systems, subject to rapid falls in asset prices and soaring volatility, can buckle, risking a cascade of effects across the real economy. In a crisis, the network of connections which enable financial systems to operate can spread and amplify damage far beyond the site of the crisis.

The collapse of Lehman Brothers in 2008 was just such a system-wide failure. It spread panic across the financial markets, triggering sharp declines in asset prices and causing liquidity to dry up. The scale and breadth of the fallout took policymakers by surprise and turned a downturn into America’s deepest US recession since the 1930s. Four years later, in the euro crisis, sharp falls in the bond prices of indebted governments threatened the solvency of banks which held the bonds. Fears about excessive government debt threatened to morph into a banking crisis. Only the European Central Bank’s commitment to buy the government bonds of at-risk countries without limit saved the day.

This phenomenon is not confined to financial systems. Just in time inventories and globally integrated supply chains struggled to cope with the vast economic dislocation caused by the pandemic. With supply and demand badly out of sync economies have faced shortages and inflation. The shock of the pandemic and a surge in energy prices has brought has, for now, relegated the world of fully stocked shelves and near stable prices to the past.

These episodes, and last week’s turmoil in the gilt markets, show how systems built for one set of circumstances can struggle when the terms of trade change. Large adverse shifts in expectations are seen in all such crises. Growing concern about the UK public finances and expectations that interest rates would need to rise sharply were at the heart of last week’s gilt sell-off. Without vast levels of support provided by European governments, the surge in energy prices triggered by the invasion of Ukraine could have morphed into a systemic economic crisis.   

Central banks work hard to identify and monitor risk across economies. Most major central banks publish regular financial stability reports. The Bank of England’s Financial Policy Committee is tasked with monitoring and taking, ‘action to remove or reduce systemic risks to the UK’s financial system’.

But economies are complex, evolving systems. Threats are often idiosyncratic and obscure. Averages can conceal extremes (Before the 2008-09 financial crisis the Federal Reserve did not see the US housing market posing a particular risk to stability. That generalisation missed the accumulation of debt and risk in the sub-prime mortgage sector which was a precipitating factor in the financial meltdown). The persistence of financial crises over time, and the unexpected nature of most shocks, testifies to the difficulties policymakers face.

A recessionary, higher interest rate environment will create new pressures across the economy and in financial markets. Last week’s gilt market turmoil is a timely reminder of the risks – and of the likelihood of stresses and surprises ahead.

For the latest charts and data on health and economics, visit our Economics Monitor:

Please join me this Thursday, 6 October at 13:00 BST for the next of our ‘Navigating Stagflation’ webinars where I will be discussing with my colleagues, Mike Barber and Daniel Grosvenor, how high energy prices could reshape the business world. Register here.

Write to us with your comments to be considered for publication at letters@reaction.life