Views from the LDI desk – February 2022

We are entering a rate hiking cycle which has gathered pace and momentum faster than any expected just a few months ago. If the decision by the Bank of England (BoE) that surprised some to hike rates by 0.25% in December 2021 was ignition, then the decision to hike 0.25% again in February to 0.50%, with 4 of the 9 members voting to hike by 0.50% was surely lift off. But what does this mean for longer dated yields and has this created an opportune moment to hedge further for those not yet fully hedged?

In this edition of Views from the LDI Desk, we review the shape of the yield curve in UK and curve flattening that has typically occurred in past hiking cycles. But as we enter a post Quantitative Easing (QE) era, with the potential for active Quantitative Tightening (QT) on the horizon and governments still running large deficits, we ask the question - could this time be different?

We have lift off

The BoE decision in February to hike by 0.25% was passed 5-4 by the Monetary Policy Committee (MPC), with the 4 dissenters not voting to hold but to hike by 0.5% instead. This was particularly surprising in that two of the dissenters were members (Mann and Haskel) who have historically been very dovish, supporting holding rates lower for longer.

While on the face of it this seems very hawkish and suggests we should expect a long series of hikes to come to control inflation, the Monetary Policy Report and comments in the press conference temper this. In the press conference afterwards Andrew Bailey stated “We should not extrapolate simplistically and assume rates are on a long march upwards”.

In its Monetary Policy Report the BoE also presented data (see top of page 8) showing CPI inflation below the target 2% after 3 years if forecasts are conditioned in line with recent market expectations prior to the meeting of rates reaching 1.5% by mid-2023.

A couple of weeks after the meeting, the market has gone far further than this, now pricing base rates at 2% by November or December 2022 with a high probability of 0.5% hikes at several of the upcoming meetings.

Market pricing of BoE Base Rate is now implying above 2% by the end of 2022

This acceleration in expectations prompted MPC member Huw Pill to challenge market pricing stating in a recent speech that “Following the market-implied path to 1.2% by the end of this year would have left inflation somewhat below target. I leave it to you to draw any implications for where the MPC sees the path of Bank Rate headed".

This caused very little reaction in market pricing, implying perhaps a lack of faith in the BoE’s inflation forecasts at this stage. January’s CPI print reached 5.5%, again beating average market consensus.

Another important effect of increasing the base rate to 0.5% was that the MPC confirmed that re-investments of proceeds from gilts held by the BoE will cease immediately. This was in line with previous messaging but does have implications for net gilt supply as we head into the new gilt remit in April, where 2022/2023 gilt issuance is likely to be in the region of £200bn, the highest net remit since 2010/2011.

The first real impact of this will be in March, where £28bn of a maturing gilt will not be re-invested – this will be followed by £70bn in 2022-2023. While gilt supply for now remains very tight as we complete this fiscal year as we approach April the picture will rapidly switch.

The MPC was at pains to flag that “active QT” where the BoE starts to sell back holdings to the market rather than allowing them to naturally roll off remains at its discretion if rates reach 1%, stating: “The Committee reaffirms that it will consider beginning the process of actively selling UK government bonds only once Bank Rate has risen to at least 1%, and depending on economic circumstances at the time. The Committee also reaffirms its preference in most circumstances to use Bank Rate as its active policy tool when adjusting the stance of monetary policy."

However, the fact the BoE surprised the market by announcing they would sell down their £20bn of credit holdings before the end of 2023 and Andrew Bailey’s historic desire to shrink the balance sheet to make room for more QE in future crisis may cause pause for thought on how much one can trust this statement.

Hiking cycles and inverted yield curves – this time is different?

Increased expectations for the speed and end point of BoE rate hikes have push 10 year and 30 year yields higher but has significantly flattened the gilt curve. This is consistent with what we’ve seen in historical rate hiking cycles, for example 1999 into 2000 ahead of the dotcom crash and 2003 to 2007, where base rates were hiked and the yield curve between 10yrs and 30yrs tended to flatten. The basic explanation for this is hikes will reduce demand, ultimately push economies into recession and lead to lower rates in the future. During some of these periods the curve was significantly inverted, albeit gilt issuance was much lower than it is today.

Historically periods of hiking have driven flattening in the yield curve

A 30 year yield is simply a product of a combination of 1yr yields, so when expectations for shorter dated yields have rapidly increased, this ripples through to longer dated yields. To understand what is actually happening to longer dated rate expectations it is instructive to look at forward starting rates.

1 year SONIA rates on a forward starting basis show there has been an increase in future rate expectations across all tenors, albeit still relatively modest

What this is telling us, is that while the yield curve is very flat, future rate expectations are higher now than they were in December 2019, before the pandemic struck but clearly much lower than was being priced just a few years back at the end of 2015, mirroring global falls in yield expectations but also domestic impacts on the growth outlook. What is also striking when looked at this way is that the market is pricing several years of higher rates to get inflation back under control.

But are these higher long dated forwards, sitting around 0.5% higher than they were even at the end of 2021, high enough? Is there enough term premium in the gilt yield curve to keep attracting investors? Compared to the last several years and over periods of similar net gilt issuance, the regression of 30yr gilt yields to the steepness of the 10s30s curve remains below historic trend– arguably by another 0.5% or so (the chart below shows this with the current red dot sitting as an outlier relative to longer dated history).

The yield premium offered by 30yr gilts over 10yr gilts appears low for the current level of yields

This historical comparison needs to be taken with a pinch of salt as we’re commencing hiking from a recent history of rock-bottom rates, so one could argue we have simply entered a new regime. This can be given further consideration by comparing the gilt curve to international comparators such as treasuries or bunds.

Over the 23-year horizon of data available, the yield differential between 10yr and 30yr gilts has shown a relatively strong correlation of 0.73 with the yield differential between 10yr and 30yr treasuries, but a much weaker correlation with bunds.

Gilt and treasury curve steepness tend to track relatively well but gilts have flattened more of late

With the Federal Reserve soon expecting to start on its own hiking cycle and the market pricing up to 7 hikes in 2022, the US treasury curve has also been flattening of late, albeit noticeably less than the gilt curve. Part of this may be caused by the strong pensions de-risking demand seen in the UK as scheme funding levels have improved, combined with a lack of supply from October 2021 to April 2022 caused by the Debt Management Office’s (DMO) remit revision.

This perhaps indicates there is scope for the recent flattening of the Gilt curve to revert. As we have touched on in recent updates, the supply picture is suddenly about to change in April 2022 as the new remit comes into force and we enter what is likely to be the biggest net issuance remit for the DMO on record.

While issuance has been higher in previous years the Asset Purchase Facility (APF) has often heavily offset this issuance prior to 2022/2023 remit

While better than expected GDP growth since the OBR forecasts used to inform the chart above were made may mean the net remit is a bit below £200bn, this will still be a record net remit. This comes before the effects of any quantitative tightening that could potentially occur later in the year are included.

There also remain a number of unknowns;

1. As we wrote about in January’s edition of Views from the LDI Desk, Pension Risk Transfer (PRT) demand is expected to be high in 2022. At the margins this means less net demand for Gilts as insurers typically swap Gilts for Swaps and Credit.
2. Hedging demand could remain high - Scheme de-risking activity and locking-in of funding improvements along with regulatory pressures on Scheme’s that haven’t adopted wholesale hedging programmes could mean significant demand from DB schemes continues.
3. Breadth of investor base may widen – As we experienced in recent syndications, especially in the context of green gilts, we’ve seen a broader base of investors and international investors bought a significant volume of gilts in 2021 - close to £100bn. Can this continue or does the threat of active QT drive them into other markets further behind on this journey, such as Europe, unless more of a term premium is built in?

What does all this mean for pension schemes seeking to increase their hedge?

As ever, unexpected events can occur that drive yields sharply lower again, for example a dangerous new COVID variant or the outbreak of conflict. The decision to hedge should ultimately be about risk management. However, we are entering a period of uncharted waters for markets.

While curves often invert in hiking cycles, the UK Government is also still running a large deficit – far larger even adjusted for inflation than we saw in periods like 2003 – 2007 when the curve last inverted. There is also the unknown of QT and the fact that while pension de-risking is still taking place, many more schemes are better hedged than they were.

Could this time be different, and we are about to enter a hiking cycle in which the yield curve steepens and longer dated yields drive higher? 2022 looks set to be a fascinating year for fixed income markets and those seeking to extend hedges may benefit from time-based triggers and taking an averaging in approach as we navigate the confusion of a post QE world.