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Views from the LDI desk – March 2023, part 2

  • BlackRock

Hike fast and break things

The past few weeks have continued the trend for high volatility in global capital markets. The rapid pace of hikes undertaken by global central banks has started to break things and expose issues, with Silicon Valley Bank and Signature Bank defaulting and Credit Suisse being hastily taken over by UBS, as nervousness about the impact of falling bond prices impacted confidence in the bank system. Demand for the safety of government bonds has pushed global yields lower, particularly at shorter tenors, and off the post gilt crisis highs experienced in early March.

In the UK we had Chancellor Jeremy Hunt’s first full budget and updates on the expected supply of gilts over the coming year, a surprisingly high inflation print and another interest rate hike from the Bank of England (BoE), taking the base rate to 4.25%.

While higher rates are causing signs of stress in some sectors of the market, the debate as to whether inflation has been tamed rumbles on and presents some difficult trade-offs for the BoE. It is likely the volatility in yields will continue.

Haven demand has pushed gilt yields lower over the past two weeks

Haven demand has pushed gilt yields lower over the past two weeks

Source: Bloomberg, Blackrock. Data as at 23 March 2023. The figures shown relate to past performance. Past performance is not a reliable indicator of current or future results.

A record setting gilt remit

Jeremy Hunt burnished his reputation for being a steady hand in the Treasury with his first full budget, introducing policies around childcare provision and pensions caps designed to increase the size of the workforce but not cost enormous amounts. The Chancellor’s position has been helped by improving growth prospects and a fall in energy prices following a mild European winter, allowing him to also extend the energy price cap at £2,500 p.a. for the average household till June 2023.

These improving conditions mean the £241bn gilt remit for 2023/2024 announced by the Debt Management Office (DMO) after the budget was significantly lower than the £300bn it was feared to be last Autumn.

Gilt Issuance – High, but not as bad as it might have been

Gilt Issuance – High, but not as bad as it might have been

Source: Bloomberg, Blackrock, UK Debt Management Office, OBR. Data as at 23 March 2023.

Despite this improvement in the funding position the net gilt issuance for the coming year is still historically high, particularly in an environment where pension risk transfer, which typically results in insurers selling gilts they receive from pension schemes, is likely to continue to grow given strong pension scheme funding levels.

Acknowledging this, the DMO have skewed issuance towards shorter tenors, hoping to make the overall size of gilt interest risk issued to the market more palatable and taking advantage of short dated yields being at levels where gilts form a more attractive component of any asset allocation than they have for the past 15 years.

The DMO continues to skew issuance towards shorter maturities and away from long (>15yr) bonds

The DMO continues to skew issuance towards shorter maturities and away from long (>15yr) bonds

Source: Blackrock, UK Debt Management Office, OBR. Data as at 23 March 2023.

With the high level of expected gilt issuance well flagged for the past six-months, the yield pickup of gilts over swaps has been at elevated levels. With sterling repo markets flush with cash as large banks receive increased deposits and lower overall repo demand with lower LDI leverage, repo financing costs are historically cheap, often just a few basis points above SONIA. While we are cautious on asset swap spreads given the supply outlook, this does create an attractive carry opportunity relative to hedging in swaps and is something we look to take advantage of in discretionary mandates.

Longer dated gilt asset swap spreads are elevated relative to low gilt financing costs

Longer dated gilt asset swap spreads are elevated relative to low gilt financing costs

Source: BlackRock. Data as at 22 March 2023. Data shown is for index-linked gilts, relative to SONIA swaps. Coloured bar is 3m range, line is 12m range.

Inflation surprises again

The headline CPI (Consumer Price Index) and RPI (Retail Price Index) numbers were released on 22 March and perhaps it shouldn’t be a surprise that they still remain stubbornly high. Headline CPI was forecast to decline slightly from last month; however, it accelerated from 10.1% to 10.4%. Similarly RPI rose from 13.4% to 13.8%.

One of the key aspects that many market participants have struggled to grapple with over the past 18 months is the persistence of inflation after the COVID-19 pandemic. Initially, the spike was driven by base effects after very low inflation prints in 2020, then followed the supply chain bottlenecks as the global economy re-opened after lockdowns and now we’re left with the puzzle of persistently high inflation even after there has been a significant attempt by central banks over the past year to tighten the policy rate.

What is driving this persistence of inflation now and why aren’t the rate hikes having enough of an impact? Well, we think there are a couple of reasons:

  1. Second round effects – an example of this is because inflation has been high for the past 12 months this level of inflation feed through into some regulated tariffs. Mobile phone bills for example often reset in April of a given year and the new tariff is based on the previous 12 months of inflation.
  2. Genuine strength in the UK economy – we spend a lot of time looking at the detail of what is driving inflation and the chart below from the ONS attributes the different factors that are contributing to high inflation. The largest contributor is Household Services (mainly electricity and gas bills) which is something the BoE has little control over. Similarly, Food and Non-alcoholic Beverages is largely out of their control and subject to the whims of the weather. However, aspects of discretionary spending such as Restaurant and Hotels are the types of areas where a rate hike should cool demand. The fact that these areas are still accelerating makes the BoE’s job harder and may mean that further rates hikes are warranted.

Cyclical categories such as restaurants and hotels continue to contribute to inflation despite hikes

Cyclical categories such as restaurants and hotels continue to contribute to inflation despite hikes

Source: ONS. Data as at 22-March-2023.

Difficult trade offs for the Bank of England

The BoE Monetary Policy Committee (MPC) voted to increase Bank Rate by 0.25 percentage points, to 4.25% at its March meeting.

The decision at this meeting, however, was a tricky one for two reasons:

  1. The data remains mixed: Evolution of data on inflation and labour market versus projections has made it harder to assume a continuation of hiking cycle into 2023. Sequential wage pressures have been below expectation and the MPC downplayed core CPI upside surprise to volatile components that are unlikely to be persistent. However, measures taken at the UK Spring Budget around extension of energy price guarantee (EPG) and fuel duty freeze were at a more generous level than previously expected by the MPC. These measures are likely to be supportive of GDP growth and may prove inflationary in the medium term. Furthermore, the OBR’s recent forecast upgrade increases the possibility that the UK might avoid a technical recession in 2023, contrary to projections in late-2022. These opposing effects highlight the importance of a data dependent approach in assessing any future rate hikes.
  2. Bank stresses conflate monetary policy and financial stability objectives: more recent signs of stress in the financial system triggered by collapse of banks have made forward outlook of the economy difficult to predict. While the MPC noted that their Financial Policy Committee (FPC) judged the UK banking system to be robust, wholesale funding costs for banks have risen in most advanced economies. This may have an impact on credit conditions faced by households and businesses and may even lead to rate cuts in a recession scenario.

These uncertainties have also been seen in market pricing of future rate hikes and chart below shows how expectations for the path of rates have moved as macroeconomic data inputs have come through and the drama in the banking sector unfolded.

Market MPC Rate Pricing

Source: Bloomberg, Data as at 23 March 2023.

Our view is that evidence of more persistent pressures in inflation from core goods will lead to further tightening in monetary policy, especially if recession risks recede in the coming months and there are signs of stabilisation in the banking sector.

What should UK pension schemes be looking out for?

  1. Volatility is likely to continue – with continued uncertainty over the taming of inflation, the resilience of the banking system to higher rates and the path of interest rates, volatility is likely to continue. This creates both opportunities and risks.
  2. Fast moving markets may favour triggers – there have been attractive yield levels on offer in the past few months. However, with the pace of moves the time between decision making and implementation is key. Yield based triggers were historically widely used but appeared to fall out of favour as yields continued to fall prior to 2022. Might current market conditions be ripe for their return?
  3. Regulatory landscape continues to evolve – at the Work and Pensions Committee meeting on 22 March, Lowri Khan, Director of Financial Stability at HM Treasury appeared to confirm that the upcoming minutes from the March Financial Policy Committee meeting due for publication on 29 March will include further recommendations on LDI liquidity buffers. This publication will be closely watched as the LDI landscape and pension scheme investment strategies continue to evolve and we will provide further update on how any announcements will be factored into our offering for our ongoing and important partnerships with our LDI clients.