Views from the LDI desk – August 2023

Sufficiently restrictive for sufficiently long

On the 3 August 2023 the Bank of England (BoE) announced its 14^th consecutive hike in interest rates, increasing rates by 0.25% and bringing the base rate to 5.25%. While this wasn’t surprising, with the market pricing a 0.25% increase as more likely than 0.5% the wording in statements from the BoE indicated that we are heading towards the end of the hiking cycle, with an acknowledgement that monetary policy was at this point restrictive. This has caused a repricing in the expected terminal rate, to below 5.75% with markets expecting another hike in September and an increasing likelihood of a pause beyond then.

BoE rate expectations moderated after inflation miss but expected to stay higher for longer

However, as we wrote about in June’s views from the LDI desk, wage growth is running above levels compatible with the BoEs inflation target given anaemic trend productivity growth in the UK. Governor Andrew Bailey admitted in his press conference that the path of wage growth was uncertain and had surprised to the upside on several occasions. With a robust (albeit gradually weakening) labour market and strong wage growth the BoE is increasingly indicating that it will need to keep rates “sufficiently restrictive for sufficiently long to return inflation to the 2% target”.

Has the BoE broken the back of inflation?

After three months of inflation surprising to the upside, the June 2023 inflation print finally delivered some welcome respite for gilts. With CPI printing at 7.9%, down from 8.7% in May and below economist survey expectations of 8.2%, longer dated yields and expectations for the terminal base rate both dropped, pulling yields back from the post gilt crisis highs in the days after the CPI release.

As the chart below shows year on year inflation growth over the past year started with energy and transport costs (black and red bars) but became increasingly broad based as heightened energy costs passed through to other inflation factors.

As a result of this broadening base of inflation impetus, the inflation beats in prior months had been driven by broad based factors. June’s undershoot followed this trend, with many categories showing signs of slowing and shrinking month on month contributions.

Year on Year inflation was initially driven by oil and energy cost increases

In particular, if we drill down there are signs that food inflation is slowing, with the month on month change shrinking to the lowest level in months and expectations from some economists that food inflation may turn negative in July’s print. While risks to food inflation remain given the breakdown of the Ukraine grain deal, extreme weather and continued wage pressures across the supply chain, this will be welcome news to the BoE and the UK government.

Month on month inflation contribution from Food shows momentum is slowing

Quantitative tightening and indigestion in longer dated yields

With the slowing of inflation short-dated yields have remained relatively stable. However, whilst longer dated yields initially moved lower as well, we are now seeing them give up some ground and move back towards the post crisis highs. This latest move is driven in good part by US government bonds.

The US Treasury has announced a substantial increase in issuance in early August 2023 while Fitch downgraded the US sovereign rating from AAA to AA+. Alongside this, there are fears that Japanese investors, the largest overseas investor in US Treasuries may begin to repatriate cash to Japan as government bond yields there rise.

All of this has led to a sharp increase in 30yr US Treasury yields, bringing gilts along for the ride.

30yr nominal gilts vs. 30yr US Treasuries

However, the UK is facing its own unique challenges around the potential supply of gilts. While active Quantitative Tightening (QT) has been underway for almost a year, recent focus has been turning to the cost to the Government of the BoE undertaking gilt sales at prices significantly below the purchase prices over the past 15 years.

A key difference between the UK’s approach to quantitative easing compared with the US or Europe is that UK Government has indemnified the Bank of England against any losses from the programme. While the Bank of Canada has done the same, they are yet to sell any purchased bonds.

The UK is an outlier in that its treasury has both indemnified the BoE against loses and bonds are being actively sold

This costs His Majesty’s Treasury (HMT) money in two ways:

1. HMT has to pay the BoE a running payment to finance its balance sheet
   • As base rates increase this becomes more costly.
   • This had been offset by an agreement between BOE and HMT that coupons would be paid to HMT, which offset the cost of funding the balance sheet while coupon rates exceeded base rate, which had been resulting in significant transfers from the BoE to HMT.
   • This relationship has reversed now the base rate exceeds almost all coupon rates.
2. HMT has to promptly cover any losses the BoE makes from selling bonds it purchased at a lower price than it originally paid
   • Given the level of current yields this is likely to result in losses on many of the bonds purchased.
   • The longer duration of the UK’s debt profile relative to many countries plus the higher percentage of outstanding bonds purchased by the BoE leaves the UK more exposed to mark to market losses.

In it’s recent Asset Purchase Facility (APF) report the BoE outlined the size of these flows and they are material, with HMT likely to be remitting tens of billions of pounds a year to the BoE over the next few years. The risk of indigestion caused by the issuance of additional bonds to finance these flows on top of already record levels of issuance feels relatively high. Unless you are a very large central bank that can afford to effectively print money (at least temporarily) to finance these losses like the Fed or the ECB, there is no such thing as a free lunch. That being said, the temptation for a future government to revisit the indemnity and mechanics of the QT programme is likely to be high.

When we compare the net remittances between the central bank and the treasury, as the table below shows the UK is now significantly worse off than the US, with this effect leading to a c. 25% increase in government issuance requirements, while the impact in the US is far more muted.

HMT benefited from higher coupon remittances when rates were low but flows have now reversed as bonds are sold at a loss and base rates exceed average coupon rates

What does this mean all mean when considering asset allocation and LDI portfolio design?

With hopes rising that we are a few hikes away from the peak in base rates, while longer dated yields continue to face a range of headwinds, a popular topic of discussion in bond markets is whether curves can steepen? The charge sheet against longer dated yields is growing:

• Quantitative tightening resulting in bond sales
• High levels of government issuance, amplified by the impacts of QT in the UK
• Sales from insurers as a result of accelerating pension risk transfer on the back of record surpluses
• Potential sales from some overseas investors, in particular Japanese investors if JGB yields increase
• Muted LDI demand for additional hedging given leverage constraints

When we regress the level of curve steepness for 10 year yields vs. 30 year yields against the 10 year yield there was a relatively stable trend pre-2022. As the 10yr yield increased the steepness of the curve also tended to increase. This relationship has weakened over the past 18 months, moving into a new regime, but plotting a trend for post 2022 data the UK curve still looks relatively flat and were it to recover its more historical relationship potentially has a long way to move. As we reach the end of the hiking cycle while high levels of issuance continue, could this relationship move toward the top right of the chart and more in line with the pre 2022 trend and a greater level of term premium?

Comparing 10yr gilt yield with steepness of the curve – curve looks flat even relative to the post 2022 trend

How might a pension scheme position itself for a UK steepening event were this to come to pass? As acknowledged by the BoE in its August Monetary Policy Report a lot of uncertainty remains. Whether this steepening manifests itself as part of a fall in yields, so called bull steepening, or generally rising yields (bear steepening) if inflation were to return or wage growth remain robust, is finely balanced. However, if a scheme has increased its allocation to credit or other fixed income assets it is quite possible that the hedge will be naturally skewed to shorter maturities where more of these assets tend to reside. Given the picture we lay out above, schemes might think twice before asking their LDI manager to entirely smooth out their hedge profile across the curve and embrace the idea of steeper curves to come while harvesting higher yields at shorter maturities.

Key takeaways

• BoE continues to hike but may be approaching the end of the hiking cycle.
• However it is looking increasingly likely they will have to hold rates higher for longer.
• Data remains key – August and September’s inflation and labour market data releases will be closely watched and could drive market volatility.
• QT pace is likely to modestly increase and is amplifying the need for the UK government to issue debt as losses are crystalised.
• Curves could steepen as a result of the above factors – potential to take both tactical positions through discretionary mandates or express a more strategic scheme level view– please speak to your usual Client PM contact if either of these approaches would be of interest.