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Views from the LDI desk – Are inflation levels inflated?

26-May-2021
  • BlackRock

In this month’s Views From the LDI Desk, we take a deeper dive into Inflation markets. There has been significant discussion around the global reflationary theme, and markets have shrugged off the headwinds of RPI reform and are testing new highs. Considering how much of a premium is embedded in RPI market levels is it time for schemes to reassess how or how much they are hedging inflation?

RP-High?

With the considerable impacts of RPI reform from 2030, we think that it is most instructive to look at the RPI curve in three segments where assessing valuations.

Looking at the next few years, there is likely to be continued volatility as the economic recovery progresses, the impacts of Brexit feed through and various Covid-related fiscal policy changes affect price levels.

The recent high inflation print we saw in US CPI, with an April YoY rate of 4.2%, strikingly higher than both the consensus of 3.5% and the previous months level of 2.6% has drawn even closer attention to the potential for inflation spiking globally in the coming months. However, whilst global inflationary factors are likely to spill over to some extent to UK RPI, it is also worth noting both the different fiscal factors at play as well as the variation between basket weights. For example, the US has a much higher weighting to energy, and lower fuel taxation to dampen oil price moves at a time when oil prices have trebled from 30-Apr-20 to 30-Apr-21.

Oil Price has been a key driver of US CPI

Oil Price has been a key driver of US CPI

Source: Bloomberg, BlackRock 14-May-21

The April print for UK RPI was also notably elevated, with the 2.9% YoY level half a percent above consensus expectations. However, despite this significant overshoot in RPI, both CPI and Core CPI remained in line with expectations at 1.5% and 1.3% respectively. Whilst we expect transitory factors to drive both RPI and CPI higher in the coming months, this high RPI print does not appear to indicate that inflation is becoming embedded in the economy yet.

While short term inflation is expected to be elevated for the reasons outlined previously, the pricing of inflation swaps can also tell us what the market expects for inflation in the longer term. For example, swap prices can be used to look at inflation expectations over the next 5 to 10 years, the so called 5y5y forward. The ‘forward-start’ nature of this measure immunises the likely heightened volatility we will see in the coming couple of years, although still looks (mainly) at the period before RPI reform and before peak pension-related demand occurs.

Looking at the 5y5y levels, we can see that they have reached highs not seen for the past ten years. This is even more striking when we consider that the last of these 5y would be beyond the RPI reform date, and hence would be linked to the much lower CPIH index. It is worth considering that since the UK began inflation targeting in 1992, the highest ever 5 year period of RPI averaged 3.71%. The inflation market is not just pricing for a short spell of transitory inflation but actually an extended spell of higher than average inflation.

5y5y RPI Swaps - last 10y

5y5y RPI Swaps - last 10y

Source: Bloomberg, BlackRock 19-May-21

At longer dated maturities, which most heavily impact the value of liabilities, the impacts of RPI reform, covered previously here, mask some of the elevated levels when looking at a simplistic historical comparison of headline RPI swap rates. What is more telling is looking at what the market for inflation swaps currently implies for 1y RPI inflation at various points in the future. Whilst these 1 year forward levels are currently slightly lower than the January 2019 levels, a period before RPI reform was being seriously discussed, we would expect to see a reduction of 80-100bps from the reform, all else being equal.

RPI - 1Y forwards

RPI - 1Y forwards

Source: Bloomberg, BlackRock 19-May-21

Breaking it down

A simplistic view would be to look at the Bank of England’s (BoE) target of 2% for CPI, extend this to CPIH (as RPI will be aligned to this index post-2030 and CPI-CPIH basis been small on average) and consider the difference between post-2030 1 year forwards and this target as a premium. However, this view neglects several factors that are worth considering:

  • The BoE has historically overshot its target slightly
  • There is scope for regime change in how inflation is targeted
  • Fundamental structural imbalances in supply and demand may be at play

Whilst the BoE has a target of CPI at 2%, and the average level for CPI since October 1992, when inflation targeting began, is exactly 2%, this misses a crucial shift. Until December 2003, the inflation target was based on another index, RPIX, and was set at 2.5%. Looking at how much the BoE has overshot the inflation target it had at the time shows that there has been a tendency to slightly exceed the target, by an average magnitude of 0.10-0.15%.

History of UK Inflation Targeting

History of UK Inflation Targeting

Source: Bloomberg, BlackRock 12-May-21

We can use this to suggest that a reasonable estimation of a long-term ‘neutral’ level for CPI (or indeed CPIH) inflation, assuming all else remains equal, could be estimated by applying this tendency to overshoot to an inflation target.

However, a further conclusion we can draw from this shift in inflation target is that there is the potential for a ‘stealth softening’ of the inflation target. Since inflation targeting began, RPIX has averaged ~0.8% above CPI. Therefore by ‘only’ decreasing the inflation target by 0.5% at the time of the target index change in 2003, you could argue that the tolerance for inflation was increased by approximately 0.3%.

If we look globally, we can see other examples of inflation targets being softened, with the Jackson Hole speech last year from Federal Reserve chair Jerome Powell, following on from their strategic review, signalling a greater tolerance to look through shorter term inflation overshoots, and the current ECB review potentially leading to a similar approach of increased tolerance of higher inflation.

Additionally, whilst it would be considered a significant departure from the current model of central banking, over long horizons we can’t fully discount the potential for a full-scale paradigm shift. Inflation targeting has been the dominant approach for 30 years, but we cannot completely rule out the potential for a shift at some point in the next 30 years.

With the recent Fed and ECB reviews, talk of a potential shorter term inflation overshoot from the BoE and continued discussion around the global reflationary theme, it is likely that the inflation “fair value risk premium” has increased in the past months. Whilst it would be a considerable stretch to suggest that this increase would be of the magnitude to compensate for the expected drop in forwards from RPI reform, it does challenge the view that we can attribute all of the increase in expected inflation to structural imbalances alone.

This leads us to two conclusions, namely that the expected level of future RPI has likely increased but that the market level has increased even more. Why might this be?

Structural imbalances – short term and long term

Forming a view that inflation may be at elevated levels is only one piece of the puzzle. There is also the question as to whether this will revert over time, and also the considerations of the implications of changing hedging strategy.

The past six months have seen a significant increase in average scheme funding levels. Many pension funds choose to hedge to their funding level, meaning that target inflation and rates hedge ratios are aligned with funding position. This has contributed to strong hedging demand over the past few months. Whilst there aren’t any obvious reasons why scheme funding will deteriorate, the tailwind to RPI demand may dissipate as funding levels potentially stabilise. There are, of course, also still some schemes who have undertaken very little hedging and may be reassessing their position as global inflation expectations grow.

PPF 7800 - Average scheme funding level (s179 basis)

PPF 7800 - Average scheme funding level (s179 basis)

Source: PPF, BlackRock 13-May-21

Some of the factors that drive structural imbalances are longer lasting. We have written in the past about how the high proportion of the UK Governments debt in inflation linked issuance relative to other sovereigns is likely to drive a more modest allocation to new index-linked gilt issuance. The OBR have projected that inflation will remain approximately 12% of total Gilt issuance in coming years.

To put this into context, we can look at a simplified illustration. If we were to assume that approximately 25% of the £1730bn of UK defined benefit liabilities projected by the PPF7800 Index, remained unhedged, at an average inflation duration of 20y, this would suggest that approximately £865mm IE01 would be required to reach ‘full hedging’. Whilst this calculation is extremely blunt, with some heroic underlying assumptions required, it is in clear contrast to the ~£45mm annual IE01 that arrived on average from 2018-20 from Inflation Linked Gilt issuance. Whilst 2021 is likely to see some step up in IE01, with the issuance requirements for Gilts expected to fade in the years ahead from the current Covid-elevated levels, this market supply and demand imbalance is likely to remain. It is noteworthy that such supply and demand imbalances are not present across all markets, where proportionately smaller inflation exposures in retirement markets do not dominate the demand for inflation linked bonds.

This significant latent demand against a constrained supply picture is a contributor to BlackRock Investment Institute (BII) projections that RPI Breakevens are likely to remain elevated over the coming years. The BII estimate that over a multi-year horizon, the global inflation picture is still under-reflected in current market pricing, as the longer-term impacts of the fiscal and monetary policy revolution seen in the last 12 months are not, in their view, fully appreciated at present.  This suggests that a simple delaying of hedging given the elevated nature of current levels could end up deferring the purchasing of RPI until costs are potentially even higher. However, with market levels for the coming years being significantly above the OBR’s projection of RPI at 3% in 2025, there may also be some compensation for deferral. Additionally, the risk premium is often considered to be upward sloping in nature. Previous estimates from BII have suggested that the risk premium would be in the region of 2-3bps per year of duration on average, with the steepest risk premium impacts in earlier years. Allowing for positions to “roll down” to shorter maturities could therefore be associated with a diminished risk premium.

It is also worth noting some of the more technical features of inflation indexation in the retirement market, which may impact levels. Many liabilities within defined benefit pension schemes are linked to limited price indexation (LPI). The most frequent variation of this has liability increases linked to RPI with an added cap on annual indexation at 5% and a floor at 0%. In the past six months we have seen a persistent increase in RPI forwards, moving them closer to the cap and further from the floor.

30y LPI(0,5) IE01 vs 30y RPI IE01

30y LPI(0,5) IE01 vs 30y RPI IE01

Source: BlackRock, 19-May-21

As most of these LPI liabilities are hedged with RPI-linked instruments, as inflation expectations increase the required RPI notional to maintain a constant hedge ratio decreases and the amount of inflation hedging demand changes as a direct result. Re-calibrations are often run infrequently, but it is possible that for many schemes, any upcoming recalibration would result in a reduction of RPI hedging notional required. This may dampen RPI interest and feed through to lower market levels.

This may be partially offset by another valuation consideration. As the impacts of RPI reform gradually feed through to scheme valuations and liability updates and the ‘spread’ applied to RPI to proxy CPI liabilities is revised down by actuaries and advisors, we would expect liabilities to increase.

Building this into a hedging strategy

There is no “one size fits all” policy for approaching inflation hedging. Asset allocation, liability details and scheme objectives should all be taken into account. However, there are several things schemes should be considering:

  • Scale inflation risks according to your risk budget and consider your end game – for schemes with very low levels of inflation hedging although valuations are high, the risk of an extended period of above target inflation is real. Fully hedged schemes may decide there is a tactical benefit to a small underweight at current valuations, however this needs to be considered carefully with the end-game objectives in mind. If an objective is buy-in/buy-out in the coming years, hedging inflation risk fully into the risk transfer could be a driving factor.
  • Understand what you are hedging – if you are hedging liabilities with caps and floors or mostly CPI, ensuring you understand your hedge ratio and don’t end up over hedged while valuations are also high is key and may justify more frequent evaluation.
  • Consider inflation linkages in your wider assets – this is important to ensure you do not end up unintentionally overexposed inflation but is also a route to consider when looking for more cost-efficient ways to mitigate inflation risks. Assets such as long-lease property, ground rents, and infrastructure may have inflation linkages. Supply of these assets may be limited in comparison to Gilts, but they can be an attractive means of offering a level of inflation risk mitigation at potentially lower costs relative to traditional public market asset classes. Integrated LDI approaches can support the inclusion of such linkages within risk and cashflow targets.
  • Look beyond RPI – while CPI remains relatively illiquid and expensive due to the strong demand from insurers, there may at times be opportunities to source inflation exposure from other bond markets at more attractive valuations. This can add complexity around currency and interest rate risks and opportunities may be short lived. BlackRock can incorporate discretion to consider other inflation markets into a range of our management styles for LDI.

The opinions expressed are as of May 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.