Views from the LDI desk – UK Edition – November 2021

October was a busy and volatile month for UK rates and inflation markets, with comments from several of the Bank of England’s (BoEs) Monetary Policy Committee (MPC) members causing extreme re-pricings, and continued volatility in energy prices driving sharp moves in inflation amongst poor liquidity conditions. We also had an expected 30-year green gilt syndication delayed to later in the planned issuance week for the first time as far as anyone on the BlackRock LDI desk can recall.

The MPC meeting and accompanying Monetary Policy Report on 4 November confirmed that despite building market expectations of a rate hike, the BoE stood firm with a 7-2 vote in favour of maintaining the policy rate at 0.1%.

This meeting came on the tail of large moves lower in longer-dated gilt yields following the Budget on 27 October, at which updated forecasts from the Office for Budget Responsibility (OBR) upgraded growth projections and downgraded the expected scarring effect of the pandemic. This led to a significant reduction of £57.8bn in expected gilt borrowing requirements for the Debt Management Office (DMO) for the remaining 2021/2022 fiscal year, sparking speculation of the potential for a premature conclusion to the Quantitative Easing (QE) program in order to smooth out the net supply picture in the coming months. However, this was also batted back by the BoE, with a 6-3 vote passing to retain the existing QE schedule. We examine what this will likely mean for those trying to hedge in the coming months.

Amongst these announcements, the second green gilt, a 2053 maturity, could have gone unnoticed. However, despite its smaller issuance size than the blockbuster first £10bn issuance, it managed to break further records with the largest order book to issuance size ratio and another strong performance in the secondary market. 

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

We have previously discussed the continued global pick-up in inflation. This remains evident in global realised inflation rates.

Global inflation has picked up in 2021

Whilst the story of high inflation is not new, there has been increased acknowledgement that the peak of inflation is likely to be elongated. There has been reference from global central banks to a confluence of factors that are catalysts behind this persistence. Both the ECB last week and the Federal Reserve meeting earlier this week referenced supply chain disruptions as key contributors to inflationary pressures. This, added to the known impacts of taxation changes (largely the unwind of previous VAT cuts in the UK and Europe) and the well-discussed spike in energy prices, means that market confidence of a swift return to the inflation target is limited. The energy price impact, with new tariffs due in the UK in April-22, is evident in the ‘twin peaks’ structure of UK RPI fixings implied by the market. During the November press conference Governor Bailey was very clear that monetary policy was not able to be used as an effective tool to tackle the causes of supply problems.

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

However, even after a small recent drop in projected levels, market levels for UK inflation remain near all-time highs.

5Y UK RPI Zero Coupon Swap Rate

Despite this, the BoE remains confident that UK CPI will revert to target over its forecast horizon. This suggests continued confidence that such inflationary pressures are transitory. Governor Bailey emphasised that he does not think of ‘transitory’ as a unit of time, but more a behavioural definition, signalling some comfort with a persisting peak. However, the concern remains that the longer the peak persists, the more risk that high inflation gets translated into higher wages and medium-term inflation expectations.

Bank of England CPI Forecast - based on Market Interest Rates

Whilst we can reconcile some of the disconnection between central bank forecasts and market levels as an increase in the risk premium representing a period of uncertainty, we can also look at reasons why the market may view inflation as potentially becoming more entrenched. Inflation expectations appear to be increasing. This is evident in the UK from the recent Bank of England/Kantar inflation attitudes survey, whilst further afield we can see the increase in the University of Michigan survey of long-term US inflation expectations in the past months:

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

The other key factor frequently cited by central banks is labour market tightness, where increasing wage pressures could lead to a wage-price spiral and inflation becoming more entrenched. Whilst UK wage data dropped slightly into late summer, it remains at historically high levels, and will be closely watched into the key wage bargaining rounds in January and April.

UK AWE Regular Pay Ex Bonus 3m Avg YoY

The BoE has flagged the strong influence of labour markets, and particularly the reaction to the conclusion of the furlough scheme, in determining the “scale and pace of response” in policy. The lack of official labour market data relating to the period after the scheme ended was cited as a factor as to why there was not sufficient comfort to raise rates at present. It is noteworthy that we see two labour market releases which will contain this data before the next BoE meeting on 16 December.

Central banks holding firm in the face of market pressure

Whilst central banks are all battling higher and more persistent inflation, they are at different stages in their policy journey. A common theme across central banks is that they are signalling rate moves at a slower pace than the market.

In the Euro Area, the ECB remains firmly in a process of expanding its balance sheet through two separate QE programs. Additionally, whilst market expectations of rate hikes are creeping forward, the first hike is expected by the market to be almost a year away. The Fed took an important step further down the road at its November meeting with the widely expected confirmation of the tapering of QE, reducing purchases of Treasuries and Mortgage back securities by a combined $15bn per month from mid-November onwards. However, the Fed has left itself significant flexibility to adjust this based on “changes in the economic outlook” as well as signalling that the conditions to raise rates in future are a very separate process from the decisions on balance sheet management.  Without a fixed QE target, in contrast to the BoE, the Fed has typically had more room to manoeuvre on QE.

Projected base rate increase from OIS Swaps

Despite rates remaining unchanged in the November meeting, the BoE is ahead on the hawkish path, both with balance sheet management (with a clear path to ceasing reinvestments and future asset sales predicated on base rate levels) and future rate hike expectations. This can be seen from the stronger pricing of future rate hikes compared to other major markets.

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

Immediate market reaction to the November meeting and future policy path expectations

Whilst markets were strongly expecting a rate increase in November, the picture from economists was more balanced. A Bloomberg survey released on 1 November showed that 23 of 45 respondents were looking for no change to the base rate. The continuation of the QE program was widely expected, with only 4 of 28 survey respondents expecting an early end to bond purchases.

However, given market expectations, the drop in front-end yields after the announcement was relatively sharp. We can see a sharp fall in yields to align with a midday rate decision announcement before a further fall into the press conference, which began half an hour later, as questions around the future outlook were answered.

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

This market reaction can be attributed to both the lack of rate move, but also to slightly more dovish language about the future rate outlook. Whilst the MPC acknowledged that, contingent on the labour market ‘it will be necessary over coming months to increase Bank Rate in order to return CPI inflation sustainably to the 2% target.’ it was also noted that inflation is due to undershoot the target by the end of the forecast horizon ‘… given the margin of spare capacity that is expected to emerge.’ The MPC was also keen to highlight that the central forecasts assumes that energy prices follow the forwards for the next six months before remaining at that (elevated) level. However, if a longer range of forwards were to be used for projection, this would also capture the expected future reversion in energy prices and would thus lead to a stronger undershoot in future inflation. The reading from this is that, in the BoE’s view, market rates are higher than is required to return medium-term inflation to target.

Gilt Supply – Famine and Feast

While the policies announced in the Chancellor’s budget on the 27 October had a limited impact on the outlook for the gilt market, all eyes were on the updated growth figures from the OBR. As the OBR only produce growth estimates twice a year, the last time these had been updated was in March 2021. During this time, the path of growth has been unusually uncertain as we exited pandemic restrictions with lack of clarity over the pace and level of recovery.

While many gilt market followers expected an upgrade in growth figures and therefore a reduction in the amount of borrowing the government would need to undertake, these estimates typically range from a £20bn to £40bn reduction in gilt issuance for the remainder of the year. The £57.8bn reduction in gilt issuance surprised everyone, resulting in the DMO having to cut 19 planned auctions in the coming five months, with the biggest of these cuts falling to short-dated conventionals (3-7 year maturity) and longer-dated conventionals (over 15 year maturity).

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

When we look at the bubble chart for the remainder of this calendar year, we can see how much of the expected issuance disappeared on the back of this announcement, with the last issuance taking place on 7 December before no planned gilt issuance until 11 January 2022, representing an extended Christmas break and potentially creating even more challenging liquidity conditions over the festive period than we usually see.

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

As the chart above shows, there will still be a new ultra-long index-linked gilt issued in late November, but the size of this is now constrained to just over £4bn with no room to upsize given there is no unallocated portion of the remit remaining.

Against this lower issuance we still have the BoE purchasing bonds as part of its QE program at a pace of £3.441bn per week, due to complete in December, leading to very low net supply in Q4 2021.

Looking forward to the beginning of next year in Q1 2022 we have the UKT 4s 2022 maturing on 7 March 2021, where the ~£25.1bn proceeds held by the BoE may or may not be reinvested depending on whether the base rate has reached 0.5% by then. If we assume proceeds are reinvested, half in March and half in April 2022, the net supply picture becomes even more depressed for Q1 2022. However, with an illustrative gross financing requirement for 2022-2023 at £215bn, if we assumed a Gilt remit of £200bn spread equally across each quarter this implies a huge step up in net issuance from April 2022, made even more extreme if we do not see a reinvestment of the UKT 4s 2022 proceeds.

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

With the yield curve at historically flat levels, those schemes with longer-term hedging programmes may wish to think carefully about whether to rush to hedge into a gilt starved market in the coming months or wait for the potential feast of greater issuance and the potential for the unwind of the BoE balance sheet later in 2022.

Reconciling the events of the last weeks and looking ahead 

In the past weeks, we have seen a significant drop in yields, driven initially by the falling supply, and subsequently by the BoE holding base rates constant and confirming the completion of the QE program. The volatility of the past weeks, coupled with the long period without Gilt supply over December/January added to the likelihood that the 16 December BoE meeting is ‘live’, with a 15bp rate hike now heavily priced in, will likely lead to challenging market conditions. However, with some large supply events, such as the upcoming 40Y+ inflation linked bond syndication due in w/c 22 November, there will be opportunities to take advantage of pockets of liquidity. Careful management of any hedging activity into year end will be crucial.