LDI Key Talking Points – October 2020

Winter is Coming…

The coming months have the potential to be difficult and volatile with a trio of challenges facing the UK economy. These include escalating COVID-19 cases leading to further lockdown measures, increasing unemployment as previous fiscal support such as the furlough scheme is scaled back, and the continuing Brexit trade deal discussions with an “Australia” (otherwise known as no deal) outcome still possible.

This combined with key upcoming events in other regions and continued uncertainty around RPI reform creates a range of areas to watch for UK LDI mandates and UK pension schemes. In this update we undertake a whistle-stop tour of key LDI market areas, considering the backdrop of these events to understand what has been happening and the outlook.

UK Economy and Bank of England Watching

Recent weeks have seen the release of weaker than expected UK economic data. GDP rose by 2.1% month on month for August, a relatively disappointing number versus economist consensus of 4.6% (source: Bloomberg). August was supposed to be the easy month, with eat out to help out boosting pubs and restaurants and no widespread local restrictions to speak of.

Unemployment data released by the Office for National Statistics (ONS) showed an increase to 4.5%, the highest in three years. Meanwhile, the Bank of England (BoE) quarterly credit survey showed that unsecured credit availability for households fell in Q3 and is expected to continue falling in Q4 as banks tighten their lending criteria.

Lower employment, less availability of credit for those suffering a reduction in incomes and increasing local restrictions do not bode well for a continued “V” shaped recovery as some members of the Monetary Policy Committee (MPC) such as Andrew Haldane had previously pointed to. The growth outlook coupled with recent borrowing eroding fiscal strength and concerns over a weakening of the institutions and governance has already been enough to prompt Moody’s to downgrade the UK to Aa3 (Stable). Taken together, this leads us and many commentators pointing to an increasing chance of the BoE announcing £50bn to £100bn of additional Quantitative Easing (QE) in their November MPC meeting, with limited alternative options currently on the table.

While negative rates continue to be discussed publicly by MPC members, the BoE approached banks directly to check on their preparedness for negative rates, with the banking sector flagging they are not ready operationally. Negative or even zero rates are still likely some months off, if used at all. With credit availability already falling, the BoE may also be cautious about taking any steps that put further pressure on the ability of banks to lend – a potential consequence of negative rates as banks struggle to pass these through to retail customers holding deposits.

Gilt Yields

Gilts took their steer over the start of October from global markets, with expectations of higher long-term Treasury issuance and talks of further US fiscal stimulus continuing, leading to a steepening in the US yield curve that dragged global yields higher and steeper. While talks on a further US fiscal stimulus deal continue in the House of Representatives, a deal in the near term now looks increasingly unlikely.

With the poor economic data in the UK and having passed through the period of peak gilt supply vs. demand in September, long-dated gilt yields have again fallen as we head into the latter part of October. 30-year gilt yields are back in the 60-80bps range they have occupied for much of the year since the announcement of QE in late March.

Gilt Yields’ brief October move higher on US led global rates move curtailed by economic realities

The Gilt market is reaching the end of the current Debt Management Office issuance remit, which runs to the end of November. While we still have some longer-dated gilt issuance to come, including the very high duration conventional 2071s, the larger syndications of longer-dated gilts such as the 2061s are now behind us. At current yield levels, the market is likely already pricing in the expected November QE. However, as weekly QE gilt buying continues and if issuance does start to tail off as fiscal support is withdrawn, with the new jobs support scheme more targeted and frugal than the previous furlough, longer-dated gilt yields could continue to grind lower in the coming months. The obvious risk to this is that lockdown measures escalate, and further fiscal support is required, leading to another bout of large-scale issuance.

Largest long-dated syndications now out of the way and net supply beginning to moderate

Gilt vs. Swap Spreads and Gilt Repo

Asset swap spreads have continued to move in a relatively tight range, of late moving back towards the bottom of the recent range as we pass through the period of high gilt issuance and QE expectations become further priced into the market. With limited long-dated index-linked gilt supply on the horizon, the additional pickup available from index-linked gilts is close to 12-month lows and this may continue while RPI reform remains uncertain, although a push to get buy-in/buy-out deals completed before year end could lead to some insurers selling index-linked gilts as they switch LDI mandates taken on into credit and inflation swaps.

Conventional (top) and Index-linked Gilt (bottom) asset swap spreads measured vs. SONIA are at the bottom of the three-month range

A key supporter of lower asset swap spreads has been the repo market, which since the events of March where spreads reached SONIA + 60bps or more has seen consistently aggressive pricing from banks. With three month repo rates at around SONIA + 15bps for the past few months, even at lower asset swap spread levels the additional pickup gilts funded by repo can offer over swaps, particularly at longer maturities, is meaningful. So far there have been no concerns reflected in repo pricing over quarter ends and no major dislocation being priced over year end, when banks often withdraw balance sheet. While a no deal Brexit remains of some concern, in the absence of this we expect the repo market to continue to offer attractive spread levels as central bank actions support balance sheet availability.

Repo financing spreads have continued to fall and are at lows for the year at shorter tenors

UK Inflation – Brexit and RPI reform

Inflation continues to be a tale of two halves, with sub 10-year inflation particularly sensitive to Brexit headlines and the associated currency moves, while longer-dated inflation continues to be directionless and flow driven as we await a response to the RPI consultation.

The main sticking points around a Brexit deal continue to be Northern Ireland, state aid, and fish. Northern Ireland and state aid, while the more material issues, appear to have scope for some compromise from both sides. While fish is economically insignificant, it is totemic and risks becoming a point that neither side feels they can be seen to back down on. While the headlines and statements from either side at times appear alarming, this could well be part of the choreography of getting to a deal that both sides can sell to their constituents, claiming that they put up a very strong fight for and achieved concessions.

Risk of no deal remains, but market pricing over the last few weeks appears to have increasingly sensed the mood music has turned more positive, with sterling tending to strengthen (albeit with bouts of volatility on headlines) while inflation expectations have fallen from the highs in September. Looking to the future, with the increasing chance of economic scarring as COVID-19 restrictions continue and the impact in the coming years of a relatively narrow trade deal, inflation expectations for the coming years could come under further pressure with many RPI swap inflation forwards over the next five years still above 3.6%, while currently RPI is printing consistently below 2%.

Shorter-dated inflation expectations have fallen as chances of Brexit deal have been perceived to increase and Sterling has regained some lost ground

At longer tenors, with a lack issuance and direction on RPI reform, pockets of flows are very much dictating short term market moves rather than anything more fundamental. As the previous issuance chart showed, supply of longer dated index-linked gilts remains very limited.  Occasionally a programme of inflation swap or index-linked gilt trading will drive inflation moves, while brokers remain cautious about their positioning with limited opportunities to adjust this via auctions and the looming threat of an RPI reform announcement.

Since recovering from March/April lows, longer-dated inflation has been directionless but subject to sharp day to day moves as liquidity remains limited with an absence of index-linked gilt issuance

No further updates have been provided on the timing for any announcement on RPI reform beyond the previous “Autumn” commitment. With the budget delayed and the Treasury firefighting COVID-19 support packages, there is a risk that the announcement is delayed into 2021. However, a natural time to provide an update would be around the spending review, expected to happen in November. Even if we get clarity then, it may take some time for the DMO to return to the market with longer dated index-linked gilt issuance. If the removal of uncertainty leads to pension schemes seeking to hedge inflation again, where perhaps they had paused programmes, could this drive a move higher in longer dated breakeven inflation even if RPI reform is confirmed? We would certainly view this as a key risk and inflation hedging to be undertaken post reform clarity may benefit from market level constraints being set.

The opinions expressed are as of October 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.