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Views from the LDI desk – UK Edition – October 2021

01-Oct-2021
  • BlackRock

The September Bank of England (BoE) Monetary Policy Committee (MPC) meeting was expected to be a non-event. It in fact provided far more guidance than expected on the MPC’s thinking around the potential pace of rate hikes, even opening the door to a 2021 rate hike.

This stronger rhetoric is driven by global energy prices and an increasingly fractious UK inflation market, causing some concern on the MPC that inflation expectations may start to become embedded and feed through to second order effects in labour markets. We explore both interlinked topics in further detail, starting with inflation, and consider what UK pension schemes should be thinking about to manage their risks and ensure an accurate hedge.

The inaugural green gilt issuance was expected to be the main event of the latter half of September. With a record order book for any gilt, at more than £100bn, and £10bn issued, the launch is broadly considered a success. But, as ever, the devil is in the detail and we outline some remaining questions on the use of proceeds that are key to ensuring a lasting positive legacy of this first issuance.

What’s fuelling higher inflation?

The reflationary theme has continued to build with both realised prints and tradable market instruments reaching ever-higher inflation rates.

The increase in inflation prints has been striking, with the Bank of England previously significantly raising forecasts in their August Monetary Policy Report, as flagged in our last Views from the LDI Desk. However, recent market moves have suggested that practitioners are expecting another increase in realised levels.

Realised RPI has continued to overshoot market projections even as they have been revised higher

Realised RPI has continued to overshoot market projections even as they have been revised higher

Source: Bloomberg, Tullett Prebon, BlackRock 30-Sep-21

The chart above shows how the inflation market has both consistently revised expectations of near-term inflation upwards and continually overshot even these revised levels.

However, whilst the high levels of realised inflation expected in the coming months is widely accepted, there remains significant debate as to whether the upcoming inflation levels can be regarded as transitory or permanent.

Some inflation effects are more obviously transitory, with a clear linkage through to prices. For example, the increase in natural gas prices will stoke inflation, even if the recent rises are unlikely to hit consumer bills until April-22, given the regulatory framework.

Natural Gas - 1st Future Price

Natural Gas - 1st Future Price

Source: Bloomberg, BlackRock 27-Sep-21

Whilst Natural Gas prices may remain elevated for a while longer, it is unlikely we will see them exponentially increase for several years. This is similar to the boost to headline inflation we saw from oil prices rebounding from their Apr-20 lows, discussed in our May Views from the LDI Desk.

There are other transitory, inflationary factors arising from the unwind of previous pandemic-driven taxation changes. The VAT cut for hospitality is due to expire at the end of September, as is the final step of the stamp duty reduction. Both will prove inflationary as they expire.

Whilst there are several such items with transitory price disturbances in the basket, one of the key questions for inflation persistence is the extent of this proliferates across the wider range of inflation index constituents. The National Institute of Economic and Social Research (NIESR) produce a series looking at a ‘trimmed mean’, removing the highest and lowest 5% of the basket.

UK CPI YoY vs NIESR 5% Trimmed Mean

UK CPI YoY vs NIESR 5% Trimmed Mean

Source: NIESR, BlackRock, 27-Sep-21

The uptick in this series suggests that the spike in inflation may be accentuated by large changes in prices of a small number of items, but there also seems to be a pick-up in the remainder of the index.

A similar picture can be observed globally. In the US, the Cleveland Fed adopts a similar approach where it looks at a weighted average of inflation rates of components whose expenditure weights fall below the 92nd percentile and above the 8th percentile of price changes. This measure is near its highest level since 1992, with only a brief five-month window in 2008 exceeding current levels.

US CPI YoY vs Cleveland Fed 8% Trimmed Mean

US CPI YoY vs Cleveland Fed 8% Trimmed Mean

Source: Cleveland Fed, BlackRock, 27-Sep-21

Whilst this suggests some risk of inflation persistence, two of the key drivers in potentially turning this into more prolonged inflation persistence are wage pressures and inflation expectations.

Whole Economy Year-on-Year Three-Month Average Growth (%): Seasonally Adjusted Regular Pay Excluding Arrears

Whole Economy Year on Year Three Month Average Growth (%): Seasonally Adjusted Regular Pay Excluding Arrears

Source: ONS, BlackRock, 27-Sep-21

Wage growth has also rebounded strongly after lockdown-based headwinds ceased. Whilst some of this, such as the well-publicised increased costs in attracting HGV drivers, may also have transitory elements, there are some signs of more permanent impacts. A recent CBI survey showed that 44% of business intended to raise pay in line with inflation with 24% planning to implement above inflation pay-rises, the highest combined percentage since the survey began in 2009.

This is also translating through to inflation expectations. The August 2021 Bank of England/Kantar Inflation Expectations Survey showed that expectations of inflation in five years’ time had risen to 3.0% from 2.7% three months ago.

YoY Inflation Swap forwards implied from Zero Coupon RPI Swaps from 1y - 50y forward start

 

YoY Inflation Swap forwards implied from Zero Coupon RPI Swaps from 1y - 50y forward start

Source: BlackRock. Data as 27 September 2021.

This has all contributed to market levels increasing across the curve. Unsurprisingly, given current pressures, the short end has led the move. However, this has permeated, to a lesser extent, across the curve. Whilst inflation demand seems relatively robust, there is a heavy supply schedule, highlighted by the November 40y+ syndication, with Q4 having approximately 2.5 times the inflation issuance by risk of Q3.

Additionally, it is worth noting that the recent moves will likely impact LPI-linked liability projections, both through the delta effect of the forwards (previously discussed in our May Update) as well as the likelihood that the next annual inflation rate fixings will exceed the 5% cap common in many liability linkages. Schemes that have not refreshed their liability cashflows year to date may wish to consider reviewing this to avoid the situation of being left unintentionally over hedging inflation.

Bank of England – talking a good game?

The MPC meeting on 23 September was not expected to be a market moving event, particularly as there was no Monetary Policy Report (MPR) to be released. The meeting did however manage to surprise the market for several reasons.

The first hawkish surprise was the fact that the vote to continue the current asset purchase program was 7-2, with MPC member Ramsden joining Saunders in voting to end early. While we do not see it as likely that the current program (which is due to run until the end of 2021) will not be completed, it still took the market by surprise that another MPC member moved to voting for this outcome.

The other surprise was a comment on the possibility of it being appropriate to increase the Bank Rate before the end of the existing UK government bond asset purchase programme. The market had been expecting any hike in interest rates to be in 2022 at the earliest, so a sentence suggesting this could happen in 2021 was interpreted as a hawkish surprise given the remaining uncertainty around the Coronavirus recovery and in particular the labour market following the end of the CJRS (Coronavirus Job Retention Scheme) in September.

On the back of this we have seen some strong market moves as well as many broker economists bringing forward their rate hike expectations to February 2022, with the risk skewed towards an even earlier hike. As we have spoken about previously in our Views from the LDI desk September piece, the Bank of England provided clarity on sequencing  in August 2021. This means when the base rate reaches 0.5% the BoE will stop reinvesting maturing proceeds from bonds held as part of the Quantitative Easing (QE) programme, and at 1% it will actively start to reduce the balance sheet. Assuming the BoE hikes 0.15% first, to a base rate of 0.25% and then in 0.25% increments, the market pricing has now moved to pricing some probability of a hike this year, with a full hike priced by Q122 and two hikes priced by August 2022, at which point QE proceeds would not be reinvested. As the below chart shows pricing has gradually shifted up, but moved significantly after the 23 September meeting.

Implied BoE base rate jumped following the latest meeting, bringing forward rate hike expectations

Implied BoE base rate jumped following the latest meeting, bringing forward rate hike expectations

Source: BlackRock, Bloomberg. Data as 28 September 2021.

We have also since had a speech from BoE Governor Andrew Bailey on the 27 September, in which it was again reiterated that if it were appropriate to increase the Bank Rate they would not need to wait until the end of current QE program.

The change in central bank tone towards the removal of monetary stimulus is not just confined to the UK – we have had similar hawkish rhetoric from the Federal Reserve who has signalled imminent tapering. What is surprising though is that this hawkish stance is coming as the economic recovery has shown signs of slowing. The Bank of England downgraded its forecast of 2021 Q3 GDP by 1% vs the August forecasts because of supply constraints including labour shortages, backlogs of work and low inventories. Central banks are so far mostly sticking to their lines that the inflation spike is transitory, driven by post-pandemic adjustments and backlogs, but could this hawkish rhetoric be a sign that central banks are more concerned about higher inflation being a more permanent phenomenon than they are letting on? While the interest rate markets appear to be buying the story, indications from the currency markets are weaker and perhaps imply a BoE trying to talk its way out of inflation with the economic realities making early rate hikes hard to stomach. The jury remains out.

Trade weighted Sterling has fallen back from recent highs despite the increased talk of earlier rate hikes

Trade weighted Sterling has fallen back from recent highs despite the increased talk of earlier rate hikes

Source: BlackRock, Bloomberg. Data as 29 September 2021.

Record breaking first green gilt issuance – but reasons to be blue?

The inaugural green gilt came with the issuance of a 2033 gilt on 21 September via syndication and a record order book of more than £100bn for the £10bn issued. Based on BlackRock’s fair value metrics we estimated a yield drop relative to the curve of around 0.5 basis points based on the issuance price, but as most non-green new issues normally come with a new issue premium (e.g. a higher yield than the rest of the curve) of around 1bps and some brokers assessed fair value for the curve to be even higher than us, estimates of the overall “greenium” at the point of issuance were often around 2 basis points.

With this greenium and the relatively short 12-year maturity, many LDI investors were deterred from taking part. Despite this, the large order book meant allocations were lower than typically seen for gilt syndications for all investors, likely driven by high demand from bank treasuries, mutual funds and hedge funds looking to profit from expected strong secondary market performance as seen in other green bond issuance in Europe. This is the means by which we undertook most participation for discretionary LDI accounts, capitalising on the scarcity premium inherent in green bonds.

With many investors missing their target allocation given the high levels of demand, the bond immediately performed strongly in the secondary market, elevating the premium to fair value to 3-4bps by the close of the first day of issuance, with a continued grind tighter over recent days as those trying to build allocations to the bond outweighed those taking profit on shorter term strategies.

Relative yield between 2033 green gilt and 2032 reference bond for syndication

Relative yield between 2033 green gilt and 2032 reference bond for syndication

The figures shown relate to past performance. Past performance is not a reliable indicator of current or future results. Source: BlackRock, Bloomberg, RBC, JPM. Data as of 28 September 2021.

While the initial issuance has clearly been a success in the market, important questions remain around the use of proceeds from the bond. In particular, the type of hydrogen technology the government plans to fund. The final road show meeting and materials provided by the Debt Management Office (DMO) around a week ahead of the issuance confirmed that both blue (fossil fuel derived with carbon capture) and green (renewable energy driven) hydrogen investments were planned using the proceeds, something that was not made immediately clear in the green financing framework issued at the end of June. More information on hydrogen technology can be found in this Bloomberg primer article.

As the overall split of proceeds use across renewable energy, transportation and energy infrastructure is not confirmed and hydrogen could, in theory, fit into any of these broad categories this raises some concerns around the total proposed use of proceeds to fund blue hydrogen. Were blue hydrogen to form a significant proportion of total bond proceeds usage, under the Green Bond Principles issued by the ICMA that drive many of the index providers assessment frameworks and the taxonomy’s at asset managers, this runs the risk of the bond not being formally classified as a green bond and excluded from green bond indices.

As we covered in our July Views from the LDI desk update, based on the green financing framework published at the end of June BlackRock assigned a preliminary medium green rating to the bond. With this continued uncertainty on the potential use of proceeds for blue hydrogen financing we withhold providing a formal final rating while we await further clarity from the DMO and Her Majesty’s Treasury. 

Further green gilt supply via syndication is expected in late October, with a 20-30 year maturity likely to be issued. While this maturity may more naturally appeal to LDI investors with larger holdings of other gilts at these maturities, the significant greenium priced into the shorter dated bond and lingering uncertainty on use of proceeds is likely to cause many investors to continue to choose not to make strategic allocations. Despite this, with global demand for green bonds remaining strong there may still be opportunities to create value for those that can participate in the syndication.