Why did the Bank of England have to rescue pension funds this week?
It was all to avoid something called the “doom loop”.
Let’s take a look.
In the minutes after Kwasi Kwarteng’s mini budget on 23 September, ongoing economic problems for the UK worsened.
The pound fell and the value of UK government bonds dropped significantly. It seems the markets were worried by the extra borrowing and the decision not to publish the usual economic forecasts.
Government bonds are essentially IOUs – a promise to pay the purchaser a sum of money in the future. When the government wants to borrow money, it issues bonds to do so.
Traders realised the government would need to issue a lot more bonds in the future to pay for the extra borrowing. With a greater supply of bonds, each individual bond would be worth less. So traders sold their bonds, boosting supply and reducing their value anyway.
The ‘doom loop’
This is key for pension funds because a big chunk of their assets are government bonds: they’re usually a safe and stable long term investment.
With the bond price plummeting, the banks started to worry about the health of the pension funds they’d lent to. After all, the bonds these funds rely on were losing value.
And so the banks began making “margin calls” – that is, asking the pension funds to stock up on cash to shore themselves up financially.
How do pension funds get hold of cash? Well, they start selling their assets, which include… government bonds.
With more on the market, the value of those bonds drops even further, and so we’re back to the start.
This is the doom loop.