What a surprise 50bps hike from the Bank of England means for your LDI portfolio
The Bank of England (BoE) surprised markets on 22 June by increasing base rates by 0.5% to 5%. Following strong employment data and another inflation upside surprise, which we will explore further below, many economists felt that a 0.5% hike was justified but doubted the Monetary Policy Committee’s (MPC) ability to deliver on this given the lack of forward guidance that had been provided.
While a hawkish move, potentially indicative of a higher terminal interest rate in the UK, comments made by the BoE that they felt it appropriate to hike by 50bps ‘in this particular meeting’ indicated that this might be a bringing forward of planned hikes, rather than an indication of 50bps hikes being the new normal. However, post the meeting the market has priced base rates at just above 6% by the end of 2023.
But the bold move was enough to prompt support for longer dated gilt yields, perhaps reflecting a view that the BoE is finally getting ahead of the curve and accelerating the demand suppression needed to cool inflation. Longer dated yields have been remarkably contained as front-end rate expectations accelerated over the course of June, meaning the impact of recent news and market pricing on most LDI portfolios has been limited. But with higher base rates comes higher Treasury payments to the BoE, while higher financing costs in general constrain the government’s budget. Can this calm in the longer dated gilt market persist through the noise and headlines of hikes and rapidly increasing mortgage rates? We think with supply picking up again in the coming months, there are certainly risks to the upside.
Expectations for the base rate have repriced materially higher over the past 4 months
Source: Blackrock, Bloomberg. Data as at 22 June 2023.
Labour markets – moving in the right direction, but slowly
Supporting the larger than expected hike, the labour market continues to be robust, with the June Labour Force Survey from the Office for National Statistics (ONS) showing a high but falling number of vacancies. Considering four key metrics from the survey:
- The employment rate, proportion of people 16 to 64 years in employment, increased to 76%, due to a significant increase in full-time employees and self-employed with the number of people in employment reaching a record high.
- The economic inactivity rate, those not in the labour force but not seeking work, decreased to 21%. During the pandemic, the number of people not seeking work had increased due to a combination of retirement and long-term sickness. However, a slow decline has been observed since Q4 2022. The decline was originally driven by students entering the workforce, while most recent data indicate a significant portion of those aged 50 to 64 years re-entering the workforce. Although the latest statistics are promising, the number of inactive people due to long-term sickness has reached a record high.
- The unemployment rate, the proportion of those economically active seeking work, moved lower to 3.8%, highlighting that rate hikes undertaken so far seem to be doing little damage to the economy.
- Wages continued to push higher, with private sector total wages reaching 7.6%, while public sector pay details also began to flow through, with an increase of 5.6%.
Wage growth’s continued strength incompatible with inflation at 2% target
Source: Blackrock, ONS. Data as at June 2023.
While the BoE may take some comfort from the fact that vacancies are gradually falling, the level of wage growth and the fact that this has accelerated again will be of concern. With UK productivity growth averaging around 1%, wage growth of around 3% is consistent with an inflation target of 2%. The arguments that we are already in a wage-price spiral are growing.
Inflation – still flying high
The upshot of this continued buoyant labour market is that headline inflation remains uncomfortably high for the Bank of England. The release this week left the headline Year-on-Year CPI rates unchanged at 8.7% where many forecasters had expected some moderation to 8.4%. This means that so far this year inflation has surprised to the upside in 4 out of 5 months and by a total of 1.4%. Whilst inflation is making some progress at falling back towards target and this month’s beat was in large part driven by a 20% jump in airfares, the fall is not as quick as the BoE expected and it is happening much more slowly than other developed market economies.
The comfort that we can take is that the RPI swap market has been a slightly better predictor about the near term path of inflation and this does show that over the remainder of the year we should continue to move lower.
Path of RPI implied by the swap market shows a continued fall in inflation but to levels still likely to be above the 2% CPI target in 2024
Source: Blackrock, Bloomberg. Data as at 22 June 2023. Projected inflation from Bloomberg based on RPI swap pricing. There is no guarantee forecasts will be realised.
With inflation prints expected to remain above the 5% inflation cap built into many liability profiles until the end of the year, schemes should be wary of the risk of over hedging as index-linked gilt future cashflows grow at full RPI while liability cashflows are capped at 5%.
What does this mean for longer dated yields?
With so much focus in the press on BoE policy and the so-called mortgage timebomb, it is important to reiterate that moves in the base rate or very short dated rate expectations have limited impact on pension scheme liabilities unless they directly feed through to longer dated yields. Over much of June, longer dated nominal and real yields have been sanguine on the short-dated rate volatility, moving within a tight range. With 2yr yields jumping on the back of the recent data releases and 50bp hike, the curve has exhibited a significant flattening.
2 year gilt yields jumped through 30 year as base rate expectations grow and long dated supply is muted
The figures shown relate to past performance. Past performance is not a reliable indicator of current or future results. Source: Blackrock, Bloomberg. Data as at 22 June 2022.
Some of this curve flattening and relative outperformance of longer dated yields may have been driven by the profile of supply over the course of June. Longer dated gilts and index-linked gilts have been conspicuous in their absence on the issuance calendar. This is set to change as we head into July (index-linked gilt syndication) and September (long nominal syndication), with longer issuance expected to materially boost the interest rate exposure the market needs to digest.
Gilt supply over June skewed to shorter tenors, but this is due to change over the coming months
Source: BlackRock, UK Debt Management Office 9-Jun-2023. There is no guarantee that any forecasts made will come to pass.
On top of this, higher base rates directly impact on government finances through the payments the Treasury is required to make to the Bank of England on the size of the balance sheet used to purchase bonds as part of Quantitative easing. Higher debt financing costs as yields have increased will also impact the government’s borrowing position. Further remit revisions and greater issuance later in the year can’t be ruled out. The June stability seen in longer dated nominal and real yields, may not last.
30yr real yields have moved in a tight range over June 2023 despite front end rate volatility and remain someway off the highs from 2022
The figures shown relate to past performance. Past performance is not a reliable indicator of current or future results. Source: Blackrock, Bloomberg. Data as at 22 June 2022. Data shown for 2052 index-linked gilt.
Key takeaways for UK Pension Schemes:
- The noise around short dated yields has not extended to longer tenors – no need for panic on collateral, despite the noise in the press.
- Supply is still likely to be heavy and is picking up again in the coming months – this could yet drive longer dated yields higher.
- The eventual path of interest rates remains uncertain, and the risk of bouts of volatility remains elevated, especially as we approach an election year – we continue to monitor clients’ collateral buffers closely and believe clients should be regularly reviewing their plans to react in a timely manner if they are called on for more collateral or putting in place delegated access to other assets through integrated LDI mandates. Please speak to your usual client PM contact if you would like to discuss this further.
The opinions expressed are as of June 2023 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.
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