LDI Key Talking Points – September 2020

In this update we look at how sustainable the UK Government debt position is and what this might mean for future issuance and the ability for the Bank of England (BoE) to allow yields to rise before this might risk creating economic instability in the wider economy. We also consider some of the key points from Governor Andrew Bailey’s recent speech at the Jackson Hole Economic Symposium and what this tells us about the scope for more Quantitative Easing (QE) to impact longer dated yields in the UK.

Finally, we cover recent changes announced at Jackson Hole on how the US Federal Reserve (Fed) plans to target inflation and the implications of this on inflation more generally, alongside the return of the spectre of Brexit to UK inflation markets.

How might the next stage in the Gilt supply and demand battle play out? 

Gilt Supply 

After the flurry of Gilt issuance and BoE buying started back in March, activity has settled of late into a more stable pattern. As we head towards Winter, with the possibility of a spike in COVID-19 cases and an expected Autumn Fiscal Statement in November, it is worth considering how much headroom the Treasury has to work with.

Debt to GDP in the UK will exceed 100% for the first time since 1961 according to the Office for National Statistics. However, this ratio alone does not mean there is not more scope for further gilt issuance. Another useful metric to consider is how reasonable it is to service this debt.

The chart below shows debt interest costs as a percentage of GDP historically. The forecasted future path of interest costs are based on the downward case Office for Budgetary Responsibility (OBR) forecasts to capture a more conservative outcome. The chart then considers how interest costs may evolve based on upward shocks to interest rates.

While Debt to GDP is reaching levels not seen for many decades, the incredibly low level of interest rates provides headroom for rates to rise by up to 1% before interest costs reach levels last seen post the Global Financial Crisis (GFC) and which prompted austerity in the UK.

What could clearly change this picture is even more Gilt issuance than previously anticipated. While the Prime Minister has ruled out an extension of the furlough scheme, costs are still likely to mount in areas such as transport, other welfare and rolling out more extensive testing programmes. Additional issuance can increase cost in two ways – firstly, it would add to the quantum of debt, but also it would likely increase the cost of interest on new bonds, as excess supply challenges demand.

Bank of England Gilt Buying 

If issuance were to pick up and push yields higher, the BoE may feel compelled to act to limit yield increases and keep monetary policy loose. The options for doing this through interest rate cuts is, of course, limited with rates at 0.10% and, as written about in previous editions of LDI key talking points, the BoE remaining cautious on negative rates.

How much scope is there for further QE? At his Jackson Hole address, Governor Andrew Bailey made the case for QE being particularly impactful during periods of severe stress, pointing to the ability to “go Big” and “go Fast” to restore market stability. While Bailey appears to have a preference to make more headroom, he also clarified that it is unlikely any QE would be unwound before a base rate of 1.5% is reached, something not currently priced ever by the gilt yield curve.

Exploring the topic of what would be the limiting factor for QE, Bailey pointed to the BoE holding too high a proportion of bonds in issue as a key constraint. Currently the BoE will not buy more than 70% of any given bond and on aggregate holds just below 30% of all gilts in issue (including index-linked gilts, which are currently excluded from QE).

As the chart below shows, this is higher than the Fed and European Central Bank (ECB), but far less than the Bank of Japan (BoJ) who have been using QE heavily for an extended period over the past decade. If more QE were needed in the UK to keep yields low even as issuance accelerated, there is plenty of scope. Also, as more issuance takes place, and the balance of outstanding gilts grows, the BoE would have to expand QE to stand still in proportional terms

Central Bank holdings as a percentage of bonds in issue

What does this mean for UK Pension Funds? 

Uncertainty abounds as the global pandemic continues to unfold, but another bout of Government spending, supported by the BoE, certainly cannot be ruled out. With short dated Gilt yields already below 0% for the next 5yrs and only rising above the current base rate in 8 years, any efforts to further suppress yields from the BoE may come at longer tenors. This can already be seen from the BoE using 3-7, 7-20 and 20+ year buckets for their bond buying vs. the DMOs shorter 3-7, 7-15 and 15+ buckets for defining their issuance profile.

Gilt Yield Curve

Another round of activity similar to the height of BoE purchases over Q2 is perhaps unlikely, but if this same pattern of issuance and BoE buying continues for longer, it could well suppress longer dated yields further and flatten the yield curve. On the flip side of this, there is still scope for yields to rise to some extent whilst keeping the Governments historically high debt levels sustainable.

UK Pension Funds should consider scaling unhedged risks accordingly. While there may be opportunities to hedge at higher yields as issuance continues, longer dated yields are not by means guaranteed to have reached their lower bound.

Global Inflation – above average? 

While Bailey’s speech was of interest, the real news at Jackson Hole came from Fed chair Jerome Powell who announced the Fed would be moving from flexible inflation targeting to average inflation targeting. In effect, changing the inflation target to an average 2% over an undefined time period and making provision for inflation to be allowed to run above target for a period of time to bring the average back to target.

Detail from the speech was light in terms of the look back period to be used. Considering US inflation (measured by CPI) over the past 10 years has averaged 1.7%, does this mean we should expect the Fed to target 10yrs of average inflation at 2.3%? The framework provides a lot of wriggle room but opens up the possibility of the Fed continuing to run very loose policy for an extended period of time, even with inflation above target.

US CPI YoY prints and average of these from Jan 2010

What this new framework does not do is provide much in the way of detail on how the Fed intends to generate this higher inflation to pull the average back up. This may come through further forward guidance in future updates. Perhaps there is also some hope that this framework itself can breed inflation expectations that become self-reinforcing. However, past precedent isn’t necessarily supportive, after the ECB changed it’s target from “below 2%” inflation to “below but close to 2%” in 2003, average inflation has fallen.

This announcement was expected at some point (the BlackRock Investment Institute wrote about this in June 2019)  but has perhaps come sooner than some had expected. US 5yr inflation expectations continued their climb immediately following the announcement but have since fallen again on weaker equity markets and oil prices. Just saying it will be allowed to happen may not be enough to make it so for the Fed.

5yr GBP RPI swap vs. 5yr USD CPI swap

In the UK, the BoE does not have the same ability at this point to purposefully and explicitly allow inflation to run above target for extended periods, however they may look through short bouts of inflation caused by external factors and take a more medium term view. That said, with Brexit back in the headlines the BoE may not face the same challenges as the Fed and ECB in the near term. With the threat of no deal growing on recent headlines around the UK willingness to walk away from negotiations focus is growing on the tariffs this could bring. This, combined with Sterling weakness, has meant that short dated inflation expectations have begun to gather pace again in the UK. With a choppy few weeks likely ahead on the Brexit front, volatility is the only thing that feels relatively certain for UK inflation, while we all continue to patiently await any news of the RPI reform outcome.

The opinions expressed are as of September 2020 and are subject to change at any time due to changes in market or economic conditions. The above descriptions are meant to be illustrative. There is no guarantee that any forecasts made will come to pass.