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Views from the LDI desk – January 2022

  • BlackRock

Since our last update in November, the emergence of the Omicron variant has changed the outlook for the impact of the pandemic over the coming months. Many central banks have acknowledged that describing inflation as transitory is wearing thin and the Bank of England (BoE) increased base rates, surprising some, for the first time since August 2018.

In this edition of Views from the LDI Desk, we reflect on some of the events and data from a busier than typical December and consider some of the key trends likely to drive yields and inflation over 2022, while acknowledging the unknowns that continue to persist.

Inflation and the labour market – transitioning away from transitory

Surging inflation was one of the major stories of 2021 and this continues to be a global phenomenon. High energy prices, supply chain bottlenecks and strong housing markets all drove inflation higher. Throughout most of the year, central banks firmly held onto the line that this inflation was transitory, a consequence of bottle necks caused by the post-lockdown re-openings or other one-off effects that would moderate as demand shifted from goods to services. 

Year on year global inflation has surged throughout 2021

Inflationary pressure continues to build, but central banks talk down expectations of action

Source: BlackRock, Bloomberg, Tullett Prebon 13-Dec-21. There is no guarantee forecasts will come to pass.

In the UK, future moderation is expected to be slower than in other regions driven by the gradual impact of increases in energy prices caused by the OFGEM energy cap, which is currently set semi-annually and limits how much of any wholesale increase in energy prices can be passed through to households. The next revision of this under the current regime is in April, when it is expected that household energy bills will rise sharply, prolonging the period of higher inflation, even if wholesale energy prices do begin to stabilise.

Inflation in the UK has consistently exceeded market expectations over the past 12 months, with a confluence of factors including COVID impacts, Brexit, supply chain issues, tax changes, natural gas prices and housing market strength all playing a part.

Realised RPI has consistently overshot market expectations

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

Source: BlackRock, Bloomberg, Tullett Prebon 13-Dec-21. There is no guarantee forecasts will come to pass.

If we consider what the major contributors to inflation have been over time it is clear that inflation is starting to creep into a wider range of categories. It is likely this, along with strong signals from the labour market, that has caused central banks to move away from the transitory narrative and begin to fight back, as we describe in the next section.

An increasing number of inflation categories are running well above the 2% target

5Y UK RPI Zero Coupon Swap Rate

Source: ONS. Data as at November 2021 inflation print. Categories are grouped by number and on an unweighted basis. Based on CPIH. Categories above 4% include Alcoholic beverages and Tobacco, Furniture, household equipment and maintenance, transport, education and restaurants and hotels.

The biggest fear of central bankers is second order inflationary effects creating a wage-price spiral. Workers demand higher wages as inflation expectations increase and this cycle becomes self-reinforcing and difficult to break without more significant increases in rates that may ultimately lead to recession.  But is there any evidence of this starting to happen?

Wage growth has been strong, particularly as economies opened up, although a part of this growth year on year is following on from periods in 2020 when a high proportion of workers were on furlough and signs of moderation are now occurring as these furlough base effects drop out.

UK Average Weekly Earnings (AWE) have shown strong growth but signs this is moderating

Bank of England CPI Forecast - based on Market Interest Rates

Source: BlackRock, Bloomberg, 13-Dec-21. UK AWE Regular Pay Ex Bonus 3m Avg YoY

As we highlighted in the November edition of Views from the LDI desk, Inflation expectations are elevated globally and are showing signs of ticking up in the UK, albeit from a historically modest base and by no means in an uncontrolled manner at this point.

UK survey-based inflation expectations show signs of an upswing, particularly in the near term

University of Michigan 5-10Y Expected change in Prices (median)

Source: Kantar. Data as at November 2021. The household surveys ask about expected changes in prices but do not reference a specific price index. Summarised as a weighted median.

But the latest labour force survey from the Office for National Statistics (ONS) shows strong employment and high vacancies, even following recent end to the furlough scheme in September. Does this show continued strength in the economy, justifying significant increases in interest rates or are there other structural effects at work?

UK Unemployment Rate has fallen, approaching pre-pandemic levels despite end of furlough

UK AWE Regular Pay Ex Bonus 3m Avg YoY

Source: ONS. Data as at December 2021.

Significant jump in job vacancies as the re-opening gathered speed, reaching a record high

Projected base rate increase from OIS Swaps

Source: ONS. Data as at December 2021.

One point worth noting is that while labour force inactivity rates are certainly at relatively low levels vs. the long term, these have ticked up over the course of the pandemic, driven by a range of factors including more students and more people who are registered as long term sick. With NHS waiting lists at around 6 million people and expected to grow, so could the inactivity rate.  This also corresponds with a period in which net migration to the UK has fallen post Brexit and as a result of the pandemic, resulting in a shrinking pool of workers for many employers to fish in.

Proportion of workers who are economically inactive has grown during the pandemic

2Y OIS Swap rates - 3 month history to 4th Nov 21

Source: ONS. Data as at December 2021

Estimates of net migration into the UK at a 10-year low

Intraday move in 5Y Sonia swap - 4th Nov 21

Source: ONS. Data as at November 2021.  The 2011 to 2019 estimates are based on published Long-term International Migration estimates and derived from the International Passenger Survey (IPS). The 2020 estimate is based on the statistical modelling supported by admin data from March 2020 onwards following the suspension of the IPS. Estimates pre-March 2020 are derived from the IPS.

The risk of central bank fears around second order effects is that when all you have is a hammer, everything looks like a nail. Increasing interest rates to dampen perceived heightened demand and stop the economy overheating when it is in fact lukewarm and there is a structural supply issue that may be better solved by fiscal rather than monetary policy risks lower yields in the longer term. A policy mistake remains a risk.  

Central banks start to fight back

On the back of the inflation and labour market conditions outlined above, on the 16 December the Bank of England (BoE) Monetary Policy Committee (MPC) announced an increase in base rates of 0.15% to 0.25%. With a vote of 8-1, this was a significant switch around for many members from the 7-2 vote to hold rates in November, likely led by the continued strong employment data released a couple days ahead of the meeting and another upgrade in CPI expectations to now peak at 6% in April 2022. These two factors appear to have created enough concern to do something now, offsetting the clear concerns heavily referenced throughout the MPC minutes about the potential near term impact of the Omicron wave currently hitting the UK.

Since the meeting, data on the case hospitalization rate and the impact of booster vaccines has increased hopes that the Omicron variant can be managed with more modest restrictions, although the economic impacts of worker absences and behavioral changes will still likely weigh on the February meeting to some extent. The minutes are also clear that the impact on inflation of more restrictions and further lockdowns also remain uncertain, particularly if restrictions spread globally and lead to further supply chain disruptions.

Going into the meeting, and with the rapidly developing Omicron backdrop, the decision was being priced as a coin toss by the market, with just under 7bps of hikes priced for the meeting the night before, having been almost fully priced in for a 15bps hike just a few weeks before.

Expectations for the pace of rate hikes have accelerated as some positive news emerged on Omicron

Auction axe falls most heavily on shorter and longer dated conventional gilts

Source: BlackRock, Bloomberg. Data as at 04 January 2022. There is no guarantee forecasts will come to pass.

With some indications of positive news around the severity and protection offered by booster vaccines against Omicron, the market was at the time of writing pricing a further 21bps of interest rate hikes in the February meeting with expectations of rates back to 1% or beyond by the second half the year.

The BoE is not alone in its change in rhetoric and view on the need to start to take action. The Federal Reserve (Fed) also took action in their December meeting, doubling the pace of their tapering of the Quantitative Easing (QE) programme and shifting the dots on their dot plot that sets out Fed member expectations to indicate 3 rate hikes in 2022 with the first in March. While the European Central Bank is likely to be somewhat further behind in hiking interest rates, they are also considering reducing stimulus through bond buying programmes as views that inflation risks are skewed to the upside gather momentum. 

Barring a further twist in the pandemic or other unforeseen event, 2022 should be the year that we see lift off in global rates. However, as set out in the BlackRock Investment Institute 2022 outlook we expect the new nominal theme of mildly higher inflation with a muted central bank reaction to continue, meaning while we may have lift off, the ultimate destination is not expected to be stratospheric. 

Gilt supply and demand outlook in the age of Omicron

What does an environment of rising bank base rates mean for the longer dated gilt yields, both nominal and real, and ultimately the value of liabilities for UK pension schemes? Shorter dated rates and the fundamentals matter and ripple through the yield curve, but as we have covered many times previously in this series, at longer maturities a significant determinant of yields and curve shape are supply and demand dynamics.

We enter 2022 with longer dated gilt yields at historically low levels compared to the level of shorter dated yields. This likely reflects the combination of the significant QE programme that ran over 2021, robust pension fund de-risking driven by strong funding levels and strong overseas demand while the supply of gilts towards the end of the year was curtailed by better-than-expected growth.

30-year gilt yields are low relative to the level of 10-year gilt yields when compared with recent history, although significantly above the absolute lows reached in 2020

Disappearing gilts – an early end to gilt issuance for calendar year 2021

Source: BlackRock, Bloomberg. Data as at 31 December 2021. The figures shown relate to past performance. Past performance is not a reliable indicator of current or future results.

Considering the outlook for supply and demand in 2022, the picture is complex and likely to be changeable as we progress through the year.

Another large source of gilt demand in the past year has been from overseas investors. Specific data on their gilt purchases is published by the BoE and it is possible to observe a large uptick in purchases over the last 12 months, likely following the increase in yields we saw in the first few months of 2021. Whether this trend can continue is unclear. Further concerns on renegotiation of Brexit deals or the triggering of article 16 could certainly cause a drop off as was seen in the years post 2016, but for now overseas demand continues to be a significant source of support for gilts.

Overseas investors have significantly increased their purchases of gilts over the past 12 months

Famine and Feast – gilt issuance likely to display a jump around the turn of the fiscal year

Source: BlackRock, Bank of England, Data to November 2021.  

On the supply front, the picture is mixed. Stronger UK growth in late 2021 has left the Debt Management Office (DMO) needing to borrow £57.8bn less than expected over the remainder of the fiscal year. This has led to a sparse auction and syndication calendar on Q1 2022, with the main event expected to be a conventional gilt curve extension in February.

Gilt supply from July 2021 to March 2022 shows the stark drop off in Q1 issuance

Gilt supply from July 2021 to March 2022

Source: BlackRock, Bloomberg, UK Debt Management Office 13-Dec-21

With initial fears that Omicron will require further lockdowns and government support packages fading and government borrowing figures for April to November 2021 coming in better than expected the likelihood of this remaining gilt remit to April needing to be revised up and unexpected supply hitting the market now seems low. It is possible longer dated gilt yields could continue to be squeezed relative to swaps and other bond markets, albeit they could still rise in absolute terms if yields rise globally.

Longer term the supply outlook is more balanced – the 2022/2023 borrowing requirements are significant with the Office for Budget Responsibility previously forecasting over £200bn of gilt issuance being required, although depending on growth over the coming months there is scope for this to experience some downward revision. This is significantly larger than pre-pandemic issuance levels and would represent the largest issuance since £227.6bn was issued in 2009/2010, all in the absence of any BoE QE gilt purchases. In fact, a hike to 50bps in February would lead to the start of a quantitative tightening, through the proceeds of the March 2022 maturity conventional gilt held by the BoE (some £27bn) not being re-invested, further expanding the net supply picture.

Another potential source of gilt supply is from pension risk transfer activity – schemes entering buy-in or buy-out transactions with insurers. While some deals have been publicized towards the end of 2021, overall it appeared to be another muted year for activity relative to some expectations after a quiet 2020. While the pandemic is blamed by many for this by de-railing deals or focusing attention elsewhere, the availability of assets and pricing of such transactions is also likely to be playing a part.

With spreads on credit assets remaining low and robust competition for alternative assets this may continue, but some such as Mercer are forecasting 2022 to be a bumper year with up to £60bn of deals as more schemes convert strong funding positions into securing member benefits through insurance transactions. This typically leads to sales of gilts as insurers recycle the gilts they are passed into higher returning assets.

Could this additional source of supply, combined with a high DMO remit and the BoE no longer making its regular gilt purchases lead to higher longer dated yields later in the year? For nominal yields this feels quite possible, and gilts also currently look relatively expensive vs. recent history when compared to swaps.

Strong end user and Bank of England QE demand have pushed gilt yields down relative to swaps

Strong end user and Bank of England QE demand have pushed gilt yields down relative to swaps

Source: BlackRock, Bloomberg. Data as at 04 January 2021. Time series for 2047 Index-linked Gilt

However, before schemes decide to hold off on considering de-risking and await better entry levels it is worth considering the inflation picture and the impact on real yields that are the more important driver of liability valuations. Index-linked gilt supply continues to constrained by a lower allocations of total issuance than historically seen, while the recent announcement that a judicial review into RPI reform will proceed may also lead to a reticence to issue index-linked gilts around the time of the review, expected in summer 2022.

Green gilts are also expected to make up a material part of the 2022/2023 remit and we believe the market could easily see in excess of £15bn issued over the next fiscal year, with potential maximum size constrained by eligible projects rather than demand. However, despite recent news of a French plan to issue an index-linked green bond, we believe the DMO will be keen to stick to conventional issues while the green gilt curve is established, creating another hurdle to index-linked gilt issuance vs. conventional gilts.

While longer dated inflation forwards continue to look elevated vs. a 2% CPI target, we would be cautious about assuming the risk and scarcity premium priced into longer dated inflation will moderate significantly in the medium term given the fundamental supply and demand imbalance in UK inflation markets.

Long term inflation forwards well above the 2% CPI target but high inflation risk premium could persist

Long term inflation forwards well above the 2% CPI target

Source: BlackRock, Bloomberg. Data as at 31 December 2021.

In summary:

  • Many UK Pension Schemes head into 2022 with a stronger funding position than they may have expected this time a year ago and may find themselves with a heightened desire to de-risk.
  • Quirks of supply and demand timing may result in further pressure on long dated gilt yields during Q1
  • Gilt supply should ramp up as the year progresses, both directly from the DMO and indirectly from insurers facilitating buy-in/out, which may help to steepen the yield curve to more typical levels.
  • We will be living with inflation for some time to come – restrained index-linked gilt supply, strong end user demand and residual RPI reform uncertainty can maintain elevated inflation risk premiums at longer tenors.