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Views from the LDI Desk – April 2021

  • BlackRock

This months Views from the LDI Desk takes a closer look at what policy actions we might expect from the Bank of England (BoE). We look at the improving economic conditions, the likely short-term changes and the considerations that may impact the sequencing of monetary easing further down the road.

Bouncing back - an improving economic outlook

Debate on the likely course of action this year from the BoE has evolved significantly over the past months. After starting the year with live debates about negative rates, with a cut to the base rate through zero by year end priced into the curve at the start of January, we ended February with the biggest sell off in 30Y Gilt yields in the last 10 years.

February was the biggest month for moves in the 30yr gilt yield in the last 10 years

February was the biggest month for moves in the 30yr gilt yield in the last 10 years

Source: Bloomberg, BlackRock, 20 April 2021

Much of this shift has evolved from the rapidly improving outlook of the underlying economy. After seeing a drop of 9.9% in GDP in 20201, a drop in production roughly equivalent to the absolute size of the economy of Finland or Chile, the outlook for the UK economy has improved dramatically in recent months. The combination of the rapid vaccine rollout and unprecedented monetary and fiscal stimulus has led to a forecast for strong economic growth in the next couple of years. According to the Office for Budget Responsibility (OBR), GDP is expected to reach its pre-pandemic level in the second quarter of 2022, six months earlier than they forecast in November. January GDP was revised upwards to -2.2%, while GDP2 in February was positive, suggesting that we are likely to see Q1 levels that are materially less negative than the February Bank of England projection, with the most recent lockdown having a much smaller impact than previous iterations. High frequency data also paints a more promising outlook, with Open Table showing that bookings on 12-Apr were only 20% down on 2019 levels, which given bookings were restricted to outside seating, and large parts of the country saw snow suggest that consumer sentiment is positive.

This improvement in projected growth has fed through to market levels. After beginning the year below 0%, 5Y Sonia swap rates reached over 0.4% by the end of February. Additionally, whilst there is no meaningful expectation of any increase in BoE base rate in 2021, focus in the market is shifting more to when the next hike will be rather than the direction of the next move. BoE rhetoric has shifted, with Governor Andrew Bailey commenting in a March speech that continued discussion around negative rates were a recognition of the "two-sided nature of the risks we face".

5y interest rate expectations now much higher than at the start of the year and rate cuts in 2021 have been priced out

5Y Sonia Swap and market level of Dec-21 BoE Base Rate

Source: Bloomberg, BlackRock, 19 April 21

Previewing the 6th May Monetary Policy Committee (MPC) meeting

Whilst there is no realistic prospect of a rate hike in the upcoming May meeting, there are still interesting decisions to take. The most notable of these relates to the pace of Quantitative Easing (QE). Continuing at the current pace of QE would lead to the additional £150bn of Gilt purchases that were signalled in November 2020 being fully enacted nearly 3 months before the end of 2021, a date that was originally stated to align with the end of the program. As such, there is widespread expectation that we will see a slowing of the pace of QE. The May MPC meeting, with accompanying Monetary Policy Report update, has been considered an obvious setting for such an announcement of a slowing in purchase pace. With the announcement that Chief Economist Andy Haldane, one of the MPC members most stridently calling for tighter policy, stepping down at the June meeting, any comments attributed to him will be closely watched.

Order, Order! – the long-term sequencing of monetary easing

Looking further ahead, we can group the potential policy options of the Bank of England into three main approaches:

  • Rate hikes
  • Balance sheet management (ranging from stopping QE reinvestment as bonds held mature, through to more active unwind approaches)
  • Allowing inflation to overshoot (either temporarily, shifting target or an extremely unlikely full-scale paradigm shift)

Considering likely actions and possible sequencing between them is challenging, largely as a result of the situation being without clear precedent. There are several questions where we are still seeing clarity only gradually emerge: How do we re-open a global economy that has been partially closed for so long? How much scarring will have occurred? How much has ‘normal’ shifted?

Secondly, in the face of these unparalleled challenges, the reaction functions of governments and central banks have become harder to predict. The starting point we have for these discussions is also unprecedented for the UK – near zero base rates and a sizeable balance sheet of Gilts held by the BoE.

BoE now holds more Gilts than Pension Funds and Insurance Companies put together

BoE now holds more Gilts than Pension Funds and Insurance Companies put together

Source: DMO, BlackRock, 21 April 2021

Bank of England holdings from QE have recently exceeded those of the Pension and Insurance sector combined. Looking more specifically at nominal Gilts only, the picture is even more striking, with Bank of England holdings currently at 47%, and expected to reach over 50% with further scheduled buying by the end of the year. The short end of the curve, with even more concentration of QE buying, is due to see holdings exceed 60%. Whilst this is below the BoE’s self-imposed limit of 70%, and there is natural decay in the percentage holdings as issuance volumes increase, there is still likely a desire to create more headroom should there be a need to react with further QE in any future crises.

Traditional views of sequencing have focused around a “rate-hike first” approach dating back to previous BoE Governor, Mark Carney, who in mid-2018 stated that “the balance sheet would be unwound at a gradual and predictable pace…once Bank Rate had risen to around 1.5%.

However, Bailey appears to be taking a slightly different view. His Jackson Hole speech last year introduced the prospect of more dynamic management of BoE balance sheet. BoE staff were recently asked to undertake work to reconsider the most appropriate way of tightening monetary policy in the future should this be required, casting significant doubt on the previously mentioned 1.5% level and opening up a wider range of next steps.

We attempt to summarise the three different approaches and the potential impacts on transmission to the economy, inflation and costs to the Treasury in the table below.

Potential options for the BoE should the economic recovery continue to gather pace

Potential options for the BoE should the economic recovery continue to gather pace

Source: BlackRock, April 2021. For illustrative purposes only. There is no guarantee that any forecasts made will come to pass.

While the effect of a rate hike is clear cut and the BoE control the size directly, for the second option of balance sheet control there is typically an assumption that an unwind of QE will lead to higher yields but it is more difficult to quantify the size, and therefore impact. There have been estimates from the Bank of England of the impact QE had as it was being scaled up. In a Jan 2020 speech, former Governor Carney flagged that “Bank staff estimate that the MPC’s £60 billion of asset purchases in August 2016 were equivalent to a Bank Rate cut of around 50 basis points”. We’ve also seen with the 2013 taper tantrum in the US that there is the potential for significant sensitivity to the QE outlook as purchases slow.

However, MPC member Gertjan Vlieghe wrote a BoE paper in 2018 flagging that there is a potential asymmetry on QE impact as it works partly through expectations. In late 2015, the US started raising the policy rate first, leaving QE in place. Over 2017, it began to indicate a QE unwind. Despite this, and more govt bond supply occurring, the curve actually flattened. The conclusion Vlieghe came to was that “unwinding QE need not have a material impact on the shape of the yield curve, or indeed on the economy, if properly communicated and done gradually”. This aligns with the MPC previous wording that any unwind has to be “gradual and predictable”. We would contend that even if it is done in the most gradual way, through a lack of re-investment of maturing holdings, an unwind of QE would likely lead to an upward pressure on yields.

Probably the most contentious policy response would be no response at all! Whilst this would be a significant shift from the past couple of decades of inflation targeting, we have already seen some softening in inflation targeting, notably through Jerome Powell’s 2020 Jackson Hole speech suggesting that the Fed will look through to medium term inflation moves.

Whilst it still is very much a tail risk event, seeing monetary and fiscal policy become more intertwined, and resultant changes to inflation targeting is a possibility worth considering, and has also been  recently flagged by the BlackRock Investment Institute here.  The growing risk premium we are seeing in the RPI market, can be at least partially attributed to this potential. Expectations for 5y RPI swaps starting in 5y time (5y5y) exceeded 3.80% at the start of April, a 0.1% premium to the highest 5y window of realized RPI inflation since the BoE began targeting inflation in 1992. This is even more striking considering that the current 5y5y level in part stretches past the 2030 RPI reform date and hence includes some exposure to the, c.1% lower, CPI index. The cost of a period of higher inflation to the Government finances is difficult to quantify and subject to much debate. The UK has a relatively high proportion of index-linked debt vs. other economies, with roughly a quarter of Gilts by value linked to inflation, around double other developed economies. However, any increase in interest costs due to higher inflation would likely be offset by inflation linked increases in tax and other receipts.

In summary, the BoE finds itself facing an unprecedented situation, with limited room for manoeuvre. The scope to hike rates materially in reaction to any pickup in inflation is constrained by the direct impact on government finances, which might in turn starve off any recovery. Meanwhile an unwind of QE also risks a disorderly increase in gilt yields and financial instability unless carefully managed. Allowing inflation to run, which is very much not currently a formal BoE policy, with the risk it becomes entrenched, may only bring into sharper focus the constrained options available.

There is a case for higher yields in the UK, and a mixture of policy steps being taken. This will be particularly true if re-opening of the economy continues and significant scarring has been avoided thanks to the enormous Government spending during the pandemic, but the BoE will likely have to tread carefully to maintain order.

The opinions expressed are as of April 2021 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.