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The Mystery of LDI Crisis Unfolds

When we thought there was nothing more to discuss about the LDI crisis of autumn 2022, a surprising revelation shook things up. Liz Truss’s tweet hinted at a groundbreaking theory that shook Britain’s financial markets to the core – a theory that pointed towards the Bank of England’s involvement in the crisis. Could it be true?

1. The Curious Case of the LDI Crisis:
   • An unprecedented wave of unfunded tax cuts triggered panic in the bond market, sending shockwaves through leveraged pension funds.
   • The aftermath saw margin calls on these funds, forcing them to unwind their precarious positions due to insufficient liquidity.
   • As more pension funds followed suit, the market spiraled into chaos, leading to a bailout by the Bank of England to stabilize gilts prices.
2. Challenging the Narrative:
   • The Journal provocatively labeled the crisis as an “outbreak of bond vigilantism,” challenging the widely accepted explanation.
   • A recent Bank of England Working Paper introduced ‘LASH risk,’ shedding light on the liquidity after solvency hedging phenomenon present in pension funds.
   • Transaction-level data revealed the intricate details of gilt trading during the crisis period, highlighting the impact of forced liquidations on bond yields.
3. Unraveling the Truth:
   • Contrary to the Journal’s claims, the Working Paper did not overturn existing narratives but rather reinforced them.
   • Blaming the Bank for the crisis due to prolonged low-interest rates appears to be a stretch, as the roots of the crisis run deeper than monetary policy.
   • The fallout of the crisis shed light on the importance of market awareness and structural understanding, emphasizing the need for caution in economic policy decisions.

Truss’s position may remain tarnished by the aftermath of the crisis, but the revelations bring clarity to the complex web of factors that led to the LDI meltdown. The key takeaway from this saga is the critical need for comprehensive understanding and foresight in navigating financial landscapes to avert similar disasters in the future.