British prime minister Liz Truss is out after a shambolic six weeks. Her government was undone by a violent market reaction to its budget-busting proposal that sent interest rates soaring amid a selloff that, at first glance, looked like a classic example of capital fleeing a poorly run country.
- But as we've learned more about what was going on, it looks less like a standard emerging markets crisis and more like a complex series of events tied to U.K. pensions.
Why it matters: In jittery times like these, previously little-known risks in the financial system can bubble up seemingly from nowhere — with seismic economic and political consequences.
State of play: The initial selloff of U.K. government bonds following the Truss "mini-budget" announcement reflected fundamental forces. The proposal implied higher budget deficits, and more Bank of England rate hikes, lay ahead.
- But that initial selloff triggered distress among British pensions that use a strategy known as "liability-driven investments" involving derivatives on long-term bonds.
- That forced fire sales by the pensions, which created a vicious cycle of falling bond prices, higher rates, and more forced sales, until the Bank of England intervened in late September. (Here's a more thorough explainer from the Financial Times.)
- This dynamic — and the on-then-off central bank intervention — created jaw-dropping swings in U.K. interest rates in recent weeks, fueling discontent with the government.
So why are we rehashing this now? Because it's an example of the underneath-the-radar aspects of the financial system. In moments of fragility, they can explode in ways that have larger implications.
- Consider the fall of 2007, when "structured investment vehicles" buying subprime mortgage debt were at risk of failure, triggering massive losses for the big banks that created them and an attempted U.S. Treasury intervention to bail them out.
- Or in January 2008, when French bank Societe Generale discovered billions in losses by a rogue trader and caused a global market selloff as it unwound those trades. The Federal Reserve did an emergency 0.75 percentage point rate cut the next day, unaware of the unique circumstances.
- In May 2010, a "flash crash" sent markets down 9% within a few minutes, as the world feared a Greek debt default. That helped prompt the European Central Bank to back government debt over the ensuing weekend.
In each of these cases, the underlying problems would have been exposed eventually. Big American banks were exposed to massive mortgage-related losses in 2007; a severe recession took hold in 2008; and the ECB needed to step up to prevent the eurozone from falling apart in 2010.
- But the sense of urgency created by idiosyncratic crisis dynamics sped those policy shifts along, for better or worse.
- Similarly, there were deep-seated problems with the Truss government's approach to fiscal policy that likely would have revealed themselves sooner or later. But the pensions crisis put them front and center.
The bottom line: In times of financial stress, events can come out of nowhere that bring down economies and — as the British have seen — governments.
