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The size of the global pension fund industry is about US$35-40 trillion. Its sheer size makes it a systematically important industry.

Before we continue, we need to be aware of two things. First, pension funds are generally required by law to invest their members' contributions in very secure long-term government bonds. Second, bond yields are inversely related to bond prices. When bond rates go up, bond values drop.

Recently, the Bank of England had to backstop the UK pension funds subject to margin calls as a result of the relentless rise in 30-year yields.

Pension funds receive member contributions on a regular basis, invest them so that they will be able to pay out a stream of retirement cash flows (pensions) in the future. 20-30 year government bonds would be an obvious asset to buy in order to hedge the interest rate risk of pension liability.

UK pension requires at least 7% rate of return to meet their obligations they promised. When interest rates are zero and negative, pension funds simply couldn’t meet their obligations without requiring members to contribute more per month, which is politically suicidal, so going into leveraged higher risk investment products to generate higher returns is the only alternative.

The leveraged risky product that these pension funds invest in are long-term receiver interest rate swaps, which is an agreement with a counterparty through a clearing house to receive cash flows at a fixed rate against the obligation to pay cash flows at the prevailing floating rate over time. There is no principal investment up front. The only requirement is an initial margin which can be settled by posting government bonds as collateral, and variation margins are mostly settled in cash every day. This investment strategy is called LDI (Liability Driven Investment) funding strategy.

The advantage of using LDI is that pension funds can now use most of their members’ regular contributions to buy higher yielding assets like real estate, private equity, SPACs, commodities, emerging market debt and equity, etc, for better returns to meet their obligations, but most of these high yield risky assets cannot be used as collateral for the abovementioned interest rate swap contracts in case of margin calls. There is also no lender of last resort in case of crisis.

Most UK pension funds have been invested in this risky manner. The strategy worked well in a zero or low interest environment until Central Banks raised rates to suppress inflation. Now stocks fell, and bonds performed even worse, and the receive swap positions became a big headache for pension funds. 

The UK mini-budget lowers tax and subsidizes energy but not at the same time cuts government expenditure, so the market realizes that the UK government will need to print money out of thin air to bridge the gap. Inflation expectations increase accordingly, causing sterling and bond prices to drop. The drop in bond prices means that the collateral used for the interest rate swaps contract becomes less valuable. Eventually this triggers margin calls. These margin calls need to be settled within hours, and there is no time to sell assets to get the liquidity to meet these calls. Orderly execution becomes impossible, and assets are sold off in an everything must go manner at far lower valuations than initially marked, and lower asset prices further cause pension funds to rush for exit to sell the most liquid assets - gilts and stocks - to raise liquidity all at once, which raises interest rates even further. It becomes a vicious cycle, aggravating the problem and creating more margin calls, eventually causing an explosive domino-like fall in bond prices. Eventually, the Bank of England was forced to step in to buy as many long-end bonds as necessary to prevent the bond market from melting down.

What has happened in England will happen in the EU, Japan and the US… And every government response would be the same: QE infinity, because they all promised unrealistic pension and all sorts of benefits to their people.

All central banks will face the same dilemma as German Central Bank Governor Rudolf Havenstein did in the Weimar hyperinflation in the early 1920s. If he should refuse to print the money necessary to fund the deficit, he would need to borrow from the market, which would then cause a sharp rise in interest rates. This would cause massive unemployment and economic collapse during a time when Germany was so fragile that a real political convulsion would almost certainly become inevitable. As the prominent Hamburg Max Warburg, a Reichsbank director, put it, the dilemma was whether one wished to stop the inflation & trigger the revolution, or continue to print money. Clever as Von Havenstein would surely choose the latter to delay the inevitable as long as possible.

The Bank of England said it was a temporary measure to buy up to 65 billion pounds worth of bonds. What is claimed as a temporary measure will become permanent, unlimited QE, just like what Milton Friedman famously noted, "Nothing is so permanent as a temporary government program."

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Pascal's Wager is an argument put forward by Blaise Pascal in the seventeenth-century, which argues that a rational person should wager for the existence of God and live a moral and decent life as though God exists, even if the chance that God exists is very slim. This is because if God does not exist, the wager has suffered only a lifetime loss of carnal pleasures and fleshly gratifications, which is after all only a finite loss, but if God does exist, and if the wager has chosen to live immorally against God’s will, then there will be eternal damnation in Hell, which is an infinite loss.


Let the probability that God exists is δ, which is an infinitesimally small number like as small as the probability of obtaining a streak of 10000 heads in throwing a fair coin 10000 times, the probability of which is 210000 to one, which is not absolutely impossible, but statistically impossible.

 

Given that the cost of eternal damnation is negative infinity -∞, then the expected loss of not following God’s will is equal to δ x -∞ = -(δ x ) = - (even δ is an extremely small number, δ x means infinitely many δs added together, therefore δ x is equal to ), so the most rational choice is to assume God exists and follow His commands.


On the other hand, if one bets that God exists and chooses to live like a medieval monk, and if -M is the lifelong loss of carnal pleasure thereafter, then the opportunity cost or expected loss of betting on God’s existence = (1 - δ) x (-M) , where 1 - δ is the chance that God does not exist. Since δ is an infinitesimally small number approaching zero, 1 - δ is very close to one, so the expected loss is very close to 1 x -M = -M.


Now -M is a lot lesser than -, so the most rational choice is to bet that God exists.


Now let’s apply Pascal’s Wager to the Ukraine war, and determine how the West should handle the situation.


Ukraine has become the battleground for the War between Russia and Nato (=USA). If the latter had not supplied Ukraine with the necessary weaponry, technology, manpower and likely also troops in Ukrainian uniform, not to mention the mercenaries, Ukraine would not have been able to last for so long, and even fought back and forced Russia to give up some of the territories it had taken. Now the referendum to annex the four regions have been completed, and Putin and his top officials have warned that Russia has the right to use nuclear weapons to defend its territory and citizens, yet the West continues to take Putin’s threat of Mutually Assured Destruction lightly seemingly never understand what’s at stake here.


Using Pascal’s Wager logic, despite the chance that Putin would use nuclear weapon is infinitesimally small, escalation to full scale nuclear confrontation and world annihilation is a very likely aftermath, and since the cost of a complete annihilation of everything is negative infinity, the only rational choice for Nato is to stop poking the Russian bear, but to sit down and negotiate for the best settlement possible.


Sadly, I am pretty pessimistic that Nato and Russia will work out a win-win resolution to the Ukriane problem, since the US seems to have determined to contain if not dismember Russia. Also, both sides couldn’t afford to be seen weak, for Biden because the midterm election is looming, and Putin couldn’t back off as well without losing his support in Russia since the sunk cost for him is too big. There is no choice for both parties but to double down. The more successful Ukraine is in fighting back, the greater the potential for nuclear confrontation.

 

You may ask if NATO backs off and stops supporting Ukraine for fear of Russia’s use of nuclear weapons, then what if Putin is insatiable and uses the same threat to annex more Ukrainian land, even the entire Ukraine, Poland…, then how should the West respond?


I believe that the United States has backed itself into a corner.  It should not have stuck its nose into this border war. Now it faces no good choice, just like the domestic inflation problem it tries to tackle, continue QE and die later, or stop QE and die right away.


Meanwhile, Biden seems to think that its military might is invincible and is using all means available to stir up an arm’s conflict between China and Taiwan in the South China Sea by militarizing Taiwan and stealthily/unopenly legitimizing Taiwan as an independent state.


I am afraid World War 3 has likely begun. A lot of people would go down with it. The only ones benefitted are the arms dealers if we are lucky enough to escape a complete nuclear showdown.


In politics, the worst-case outcome is also the most likely outcome.


We can only hope that world leaders will remember what President Kennedy said in June 1963 after the Cuban missile crisis: “Above all, while defending our own vital interests, nuclear powers must avert those confrontations which bring an adversary to a choice of either a humiliating retreat or a nuclear war. To adopt that kind of course in the nuclear age would be evidence only of the bankruptcy of our policy–or of a collective death-wish for the world.”

Exemption: (免責聲明) 本文乃作者個人意見並不構成任何投資建議。作者不承擔任何因使用本文章所提供的資訊內容或資料所產生的直接、間接、附帶的、特別的、衍生性或懲罰性賠償,包括收入、利潤、經營、商譽等損失或其他無形損失。作者不負責任何因下載本文章所引致的電腦病毒感染、通訊系統故障或其他故障、越權存取、資料刪改、遺漏或其他錯誤、資料被盜或毀滅所導致的損失。如本協定的中、英文本出現分歧,以英文文本為准。 This newsletter represents only the opinions of the author. Any views expressed should not be construed in any way as an offer, an endorsement, or inducement to invest. In no event shall the author be liable for any direct, indirect, incidental, special, consequential or exemplary damages including damages for loss of revenue, anticipated profits, loss of business, goodwill, or other tangible or intangible losses resulting from the use of any data or information provided in this article. The author disclaims any liability and losses consequent upon the downloading of this article which results in computer virus infections, communication network failures and other failures, unauthorized access of all types, data alterations and omissions and other data errors, and data theft or destruction of records. In case of discrepancies in the Chinese and English versions of this agreement, the English version shall prevail.
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