In the quarterly Columbia Threadneedle LDI Survey we poll investment bank trading desks on the volumes of quarterly hedging transactions. This quarter, the prospect of economic growth and policy normalisation dominated until the emergence of the Omicron variant. Post the summer lull, activity was elevated both in inflation and interest rate hedging, showing a 24% and 27% increase quarter-on-quarter respectively.
Optimism characterised the start of the fourth quarter of 2021. Better than anticipated employment data and GDP growth prompted the consideration of monetary policy tightening, in the form of tapering, halting or even reversing Quantitative Easing (QE) programmes. This was combined with a rising expectation of base rate hikes, visible in higher yields. This move was a consequence of the diminishing belief in transitory inflation, bringing forward efforts to tackle it before it becomes entrenched. Despite rising gilt yields, it seemed that nothing could stop the growth in equity indices buoyed by the enormous amount of fiscal stimulus, particularly in the US. But, in late November Omicron burst onto the scene creating wobbles in confidence, the closure of borders and the reintroduction of various COVID restrictions. The UK declined to impose such shutdowns as were seen in Europe, gambling instead on its successful vaccine rollout. The NHS further impressed by managing to offer most adults a booster jab within a compressed timeframe before Christmas. Clearly Omicron is far more contagious than previous variants, quickly becoming the dominant strain. However, it has proved far less serious, principally in the vaccinated community, preventing a crisis in intensive care occupancy.
In the UK, the interpretation of Monetary Policy Committee (MPC) members’ commentary took centre stage. The market had fully priced in a rate hike in November which did not come to pass, surprising many and prompting a rapid repricing and volatility in the market. Consequently, the market assigned a precisely 50/50 chance of a ‘Scrooge’ hike in December. Despite Omicron occupying headlines, the MPC felt that the improved employment data and growth projections justified a first step in their tightening journey, with an increase of 0.15% to 0.25% and multiple further steps expected in 2022. As anticipated, the UK QE programme also came to an end in December. Its continuation throughout the fourth quarter combined with traditional hedging demand leant heavily on the relative value between gilts and swaps with gilts reaching new decade lows in early December (gilts at most expensive point relative). At the time of writing, the Bank Rate is expected to reach 0.5% by March and projections show it rising to c. 1.2% by the end of 2022. The MPC’s messaging around Quantitative Tightening (QT) are that once the Bank Rate reaches 0.5% they will stop reinvesting maturity proceeds and coupons. Once it reaches 1.0%, they will consider whether to start selling down their £895 billion stock of gilts. Our counterparties firmly believe there will be another hike at the February MPC meeting and 80% believe that this will take us to the 0.5% threshold, thus halting the reinvestment of the March 2022 gilt maturity. Interestingly there is little confidence that the Bank of England will actively unwind their QE holdings any time soon, even in the next 3 years. Whilst 2022 is light in maturities, 2023 and 2024 offer more, allowing their balance sheet to be wound down gradually, hopefully without a negative impact on the market. Indeed, many struggle to see how the combination of rate hikes and active selling down of QE could not have a materially adverse effect on the workings of the market. The first test is expected with the interest rate curve extension in February 2022, which will provide substantial interest rate risk to the market in the form of a new ultra-long gilt. For the first time in several years, we will not have the back stop of the Bank of England’s QE programme to absorb this supply.
Total interest rate liability hedging activity grew to £46.5 billion, an increase of 27% from the previous quarter, whereas inflation hedging activity increased by 24% to £24.0 billion. Activity was unsurprisingly concentrated in October and November, with a particular highlight being the index-linked gilt curve extension through the syndication of the new 2073 index-linked gilt. This extension had been long demanded by investors, reflected in the expensive nature of the 2068s, and as such the enormous size of the orderbook and heavily scaled back allocations were somewhat expected.
The chart below describes hedging transactions as an index based on risk. Note that transactions include switches from one hedging instrument into another. It should be noted that as the index is constructed by using the rate of change of risk traded by each counterparty per quarter, it allows the introduction of additional counterparties to the survey.
Chart 1: Index of UK pension liability hedging activity (based on £ per 0.01% change in interest rates or RPI inflation expectations i.e. in risk terms).
Source: Columbia Threadneedle Investments. As at 31 December 2021.
The funding ratio index calculated by the Pension Protection Fund showed further improvement quarter-on-quarter (106.4% at the end of September vs 107.7% at end December). This translated into a continuation of the persistent de-risking demand. Naturally this prompted ever more schemes to consider buy-out pricing, and the effect of these deals is visible in the price action of relative value in inflation-linked and interest rate gilts in early 2022, with gilts typically underperforming swaps in parallel to the conclusion of insurance deals.
Market Outlook
The Columbia Threadneedle LDI Survey also asks investment bank derivatives trading desks for their opinions on the likely direction of key rates for pension scheme liability hedging. The aim is to get information from those closest to the market to aid trustees in their decision-making.
The results are shown below as the number of those predicting a rise less those predicting a fall, as a percentage of the number of responses. The larger the balance, the more responses predict a rise. The more negative the balance, the more responses predict a fall.
Chart 2: Predicted change in swap rates over the next quarter.
Source: Columbia Threadneedle Investments. As at 31 December 2021
Our counterparties’ predictions for the fourth quarter were focused on central bank monetary tightening, thereby leading to higher interest rates and real yields and a reduction in 30-year inflation expectations. Whilst they were correct on the fall in 30-year inflation, their expectations for higher interest rate and real yields were not borne out. Although the Bank of England did raise the base rate in December, by that time yields were contending with the prior months of non-action and the Omicron variant. Additionally, the expectation of future rate rises did not appear to noticeably dent de-risking demand.
For the first quarter of 2022, our counterparties are confident of a rise in all three metrics, with particular conviction for interest rates. This expectation is based upon the anticipated monetary tightening from the US and UK, and even perhaps the EU. As asset purchase programmes are tapered or reach their conclusion, it removes much of the downward pressure on yields. However, as a counter to this, there may be periods of reversion as potential further variants come to disturb the market. In support of higher yields, there is also the supply backdrop to consider. There is still significant fiscal funding required to cover COVID measures and, without the comfort of QE programmes, this additional supply would put upward pressure on yields. However, if there is a significant reduction in the remit at the 2022/23 upcoming announcement, this could counter yield rises.
As regards inflation, the macro backdrop supports the hope of strong growth, yet with the continuation of supply side constraints and pressure on wages from the labour market. There is a dearth of index-linked gilt issuance compared with expected de-risking demand which also supports higher inflation pricing. Opposing this is the potential impact of the judicial review in RPI reform which has the (slim) potential to result in asymmetric outcomes for gilts and swaps referencing RPI. The movement higher in inflation rates could also be halted by faster than anticipated monetary tightening and recognition that RPI inflation pricing is close to levels seen prior to the RPI reform decision, with the question remaining as to whether that is appropriate.
