May began with a flurry of central bank activity as both the Federal Reserve and Bank of England (BoE) hiked rates again as they continued to walk the tight rope of trying to contain inflation by raising rates but not so much as to crash economy. Expectations for further rate hikes and the commencement of Quantitative Tightening have driven nominal and real yields to recent highs. We explore the outlook for the UK economy in more detail, what Active Quantitative Tightening might look like and how higher yields are impacting on schemes.
BoE Balancing Act
The challenge faced by the BoE is that the data points to a red-hot jobs market and multi-decade high inflation prints but this is set against a GfK consumer confidence survey, which fell to the lowest level in 40 years, a contraction in UK GDP for March and below trend retail sales.
The UK labour market report for January to March underlined continued tightness in the labour market and upward pressure on wage growth. However, while there was a surprise fall in unemployment to 3.7% (with more job vacancies than unemployed people for the first time since records began), the UK workforce continued to remain smaller than before the pandemic due to large numbers who say they are neither working nor job-seeking. The numbers behind the inactivity rate were also quite revealing, with far more young people between 18-24 without work than before the pandemic and an even larger number of those in the 50-64 years category yet to return to the workplace. In a potential sign of the impact the COVID pandemic has had on the overall health of the nation, there was also significant rise in the number of people for whom long-term sickness is preventing their return to the workplace versus pre-pandemic levels.
Unemployment rate plumbs new lows despite employment rate lagging as numbers of economically inactive continues to run higher than the past few years
Source: BlackRock, ONS. Data as at May 2022.
The BoE were likely focused on the wage growth data contained within the report which showed strong growth, particularly in construction and finance sectors, and will likely set off a warning light around concerns of second round effects. However, while total pay (including bonuses) continues to grow faster than prices on average, underlying earnings excluding bonuses are now falling sharply in real terms especially in the public sector.
Nominal pay growth continues to run at elevated levels, driven in part by bonuses, while real pay growth turns negative for many
Source: BlackRock, ONS. Data as at May 2022.
April’s UK inflation print came in with CPI at 9%, driven by soaring gas and electricity bills. While it was marginally below expectations of 9.1%, it is now at its highest level in more than 40 years and double the rate the BoE expected only six months ago. There was evidence of inflation bleeding from the prices of goods into core services which indicates a growing domestic and more persistent component to inflation.
Previously goods driven inflation starting to feed through to services
Source: BlackRock, ONS. Data as at May 2022.
With high inflation and a tight labour market, the pressure on the BoE to avoid an extended inflationary period and wage price spiral is growing. Market expectations for hikes are being tempered by the natural demand reduction effects likely to be caused by the much written about cost-of-living crisis caused by the current inflation spike. Indicating the first signs of this feeding through are positive but well below trend retail sales for April and services Purchasing Manager Index surveys falling sharply, as the hit to disposable income for the consumer bites.
Ultimately, the BoEs remit is to control inflation in line with the 2% target and the risk of doing too little and allowing a wage price spiral to embed itself into the UK economy is real. Longer term this would likely lead to more hardship for the lowest paid in society and so talk of government support packages will continue to abound. We continue to believe further hikes will be necessary given the tightness of the labour market and wage growth, but that the peaks of recent market pricing were probably overdone, for example periods where the market was pricing base rates at 2.5% by the end of 2022.
The continued uncertain outlook for short-dated rates is likely to feed through to longer dated yields but curves remain flat and what ultimately could influence longer dated yields further is the commencement of Active Quantitative Tightening.
Active Quantitative Tightening
In its May 2022 Monetary Policy Report (MPR), with base rates at 1%, the BoE confirmed that their staff will start work on a strategy for UK government bond sales (Active QT). They will provide an update in the August 2022 MPR, which would then give them the option to start a gilt sales program at any meeting in future.
While reduction of UK government bonds from its balance sheet is not perceived to be an active monetary policy tool, by ceasing to reinvest proceeds of maturing assets they have passively started reducing their stock of assets (Passive QT).
The chart below plots the passive maturity profile of the BoE’s gilt holdings over time. Without Active QT, their holdings are likely to halve by end of 2030, at an average annual rate of c. £45-50bn. If they complement this with Active QT of c. £20bn p.a., it will halve their holdings by 2027. While there is little precedence on how an Active QT programme might operate , the design and implementation are expected to be well telegraphed to preserve market liquidity conditions and the BoE are already engaging key market participants, including BlackRock, on its potential operation.
Passive and Active? Potential paths of Quantitative Tightening
Forecasts may not come to pass.
Source: BlackRock, BoE. Data as at May 2022.
On the LDI desk, we have been debating how an announcement of Active QT could impact our client portfolios and whether it could start to unwind the effects of Quantitative Easting (QE) in the medium to long term. If they were to reverse the Asset Purchase Facility (APF) like for like, it would make sense to sell in 3 constant maturity buckets of short (3-7y), medium (7-15y) and long gilts (15y+). This would maintain the c. £50bn per annum passive roll down on sub 3y maturity Gilts and longer maturity Gilts will be slowly sold in equal market value proportion.
In this approach, as sales are cash matched across the curve, the PV01 supply in long maturity bonds will be higher. This imbalance may trigger structural steepening of the gilt curve. BoE Governor, Andrew Bailey, has previously indicated that reducing the balance sheet down to zero may not be an equilibrium level versus commercial bank reserves – implying that at some point they may stop reducing balance sheet.
With these factors in mind, we view the market impact of any Active QT could be path dependent – around speed of Active QT and structure (split across buckets). Our central expectation would be for the gilt curve to be steeper and some marginal effect on asset swap spreads resulting in cheaper gilts.
Percentage breakdown of APF holdings by maturity bucket
Source: BlackRock, BoE. Data as at May 2022.
What about the “Special Ones”?
A side effect of APF has been reduced free float of the individual gilt stock as the BoE made purchases. This is most pronounced in sub-10-year maturity range, with gilt repo trading at a negative spread to the General Collateral (GC) rate – i.e. trading special as the market terminology goes. In a nutshell, if you hold these bonds you can repo them out and receive cash on which you will pay an interest rate below SONIA as the market is unable to source enough of these bonds and will pay a premium to get their hands on them.
This specialness has also been visible in the evolution of asset swap spreads in 2022 – while long end gilts have cheapened marginally on asset swap, sub 10y gilts have richened materially (see chart below).
Short-dated gilts have significantly outperformed swaps year to date
Past performance is not a reliable indicator of current or future results.
Source: BlackRock. Data as at 19 May 2022.
It’s tricky to attribute this move with certainty, but the timing has coincided with rate hikes by the BoE. The Standing Repo Facility (SRF) is a mechanism offered by the Debt Management Office to supply gilts experiencing shortages to the market. As rate hikes have been realised, the difference in the cost of borrowing these special gilts through the SRF relative to borrowing cash at base rate has increased from 0.25% at end of 2021 to 0.75% in May 2022.
Rises in base rates have correlated with falls in the cost to repo shorter dated gilts
Source: BlackRock. Data as of 24 May 2022. Spread to SONIA is for repo on 22-Oct-2030 Conventional Gilt.
With market expectations for June and August rate hikes by the BoE high, the base rate to SRF spread is also likely to widen further. This may result in increasing specialness and richer asset swap spreads in the short term for these sub 10yr gilts. While it’s debatable if all hikes priced by the OIS curve will be realized (at time of writing the market is pricing 2.4% by May 2023), extrapolating the effect of base rate to SRF widening could drive it to 1.25%-1.50%, taking asset swap spreads richer with them. Without a material increase in short end gilt supply or substantial Active QT, it is difficult to point to many factors that reverse this effect in the short term.
As LDI investors, the silver lining in this specialness is that repo costs on structural holdings of sub 10y Gilts are at an attractive level. Sub 10y gilt holdings can be used for repo at c. SONIA - 0.3% or less, resulting in significant pick up relative to repo on longer dated gilts which cost between SONIA and c. SONIA + 0.1%. This presents an opportunity to take advantage of sub 10y Gilt holdings and reduce investment drag from the cost of borrowing.
How are rising yields impacting on schemes?
Over the start of 2022 we’ve seen a significant increase in overall scheme funding levels. The PPF 7800 index which is used as a general barometer for the health of DB pension funding has improved over 10%, with the aggregate scheme funding position increasing to 114% in April 2022 vs 104% in April 2021. Note that this is on a PPF (Section 179) basis, therefore whilst not directly comparable to schemes technical provisions or end-game basis, provides a useful barometer on the general health of DB pension funding.
This funding improvement has been driven by a few key factors
- Real yields have come back from the brink; we’ve seen a 1% improvement in Real Yields since the start of the year, and we are now breaking into levels that we haven’t seen post-brexit. For scheme’s that haven’t fully hedged (of which many remain) this will be providing considerable benefit.
- Inflation is providing a windfall to some schemes, as we wrote about in April’s Views from the LDI Desk; the impact of capped inflation, and scheme’s using RPI-linked assets to hedge their capped and floored liabilities has in many cases been positive, especially as inflation is running at 5% over these caps.
- Finally, growth assets have remained resilient when viewed over a longer horizon of the last two years, further supporting funding levels which provides a good opportunity for schemes to rotate their asset allocation and look to de-risk from high-growth portfolios towards their end-game.
Jump in 30yr Real Yields has improved funding levels despite growth assets backtracking on some post pandemic gains
Source: Barclays Live, PPF7800 Index. Data as at May 2022.
For schemes that have historically fully hedged their funding level the gains may have been more modest and in some cases the move higher in yields may be starting to test collateral levels. Attitudes to collateral management are shifting as a result of the recent moves in yields and subsequent pressure this can create to adjust asset allocations and manage the governance of where to find more collateral. We believe that running the broader matching portfolio in an integrated fashion pays dividends; whether that be for the purpose of matching cashflows or ensuring that you have a robust and well thought-out collateral waterfall that can be managed on a dynamic basis overtime.
Although we’ve seen a tough period in equity and other growth assets over the course of 2022, the gains post-pandemic remain significant. Combined with rising real yields, some schemes now have an opportunity to lock-in longer term gains and de-risk their broader asset allocation. As part of this, it’s likely we’ll see more investors turning to credit markets as their asset class of choice for their journey to endgame. This is supported by the relative attractiveness of Credit compared to recent history as a result of the 2022 re-pricing.
Source: BlackRock, CitiVelocity, Bloomberg. Data as 12 May 2022.
We see value in credit markets for schemes looking to increase cashflow certainty and de-risk against further equity downside, especially in shorter-dated Investment grade credit where carry is now higher from moves in spreads, and break-even levels have improved considerably over the last 12 months. In addition, we see high-quality securitised credit as an area of potential value for investors that want a complimentary allocation to credit which provides diversification through exposure to underlying drivers of the real economy (i.e. mortgages, consumer credit cards, autos etc) and an up-in-quality rating profile at a time when the economic picture remains uncertain. Calibrating the right mix of assets from across the fixed income complex such that sufficiently liquid assets remain on hand to convert to collateral should yields increase further remains a key consideration.
