A snapshot of the UK inflation market
Supply outlook
As fiscal year 2022/23 draws to a close, and with the market already looking ahead to the Spring Budget scheduled for 15 March, focus has begun to turn to next year’s gilt issuance remit. Minutes from the annual consultation with end gilt investors and market makers indicated tepid appetite for meaningfully upsizing of the proportion allocated to index-linked gilts, reflecting the larger cash borrowing amounts compared to FY 22/23, but also limited visibility on further de-risking flows. This has been borne out with LDI activity year to date being much lighter than usual – as the events of last September / October continue to weigh heavily on pension scheme decision making.
Going forward, the trend by the UK Treasury and Debt Management Office to reduce the proportion of linker issuance as a percentage of the total gilt remit has been largely concluded, with this fiscal year likely to finish around 11.6%. This is a far cry from the period between 2013 and 2018 when it averaged around 25%. However, this is against a backdrop of increased investor cautiousness, suggesting vulnerabilities in the index-linked gilt market are still fresh in investors’ minds with many questioning how much supply the market could digest in light of uncertain support from the LDI investor base.
The average duration of index-linked issuance for FY 22/23 was above those of previous years reflecting the fact that both syndications were of the longest 2073 index-linked gilt. We do not expect this to be replicated next year and expect a rebalancing shorter in the average duration of issuance.
This leaves a more constructive picture for long-dated gilt inflation, where the supply picture is less crowded for the rest of the fiscal year due to the Bank of England quickly concluding its sales of index-linked gilts by mid-January. However, much will depend on the demand side of the equation, which means that the market in the long end lacks a natural anchor and may end up buffeted by competing flows underpinned by relatively thin liquidity and market depth.
Figure 1: Inflation-linked issuance1, February 2023
Source: Columbia Threadneedle Investments, DMO
Figure 2: Distribution of inflation exposure issued, by maturity buckets, February 2023
Source: Columbia Threadneedle Investments, DMO
Market liquidity
Outside of the illiquidity typically experienced over the festive period, market conditions have reverted to pre-LDI crisis levels of volatility and hence bid-offer spreads have tightened. The dispersion of trading costs has also reduced, with only a couple of exceptions.
At the 10, 30 and 50-year tenor points respectively, mean bid-offer spreads2 were 1.4bps, 1.2bps and 1.5bps for RPI swaps; and 1.5bps, 1.2bps and 1.4bps for index-linked gilts.
Figure 3: Liquidity tracker based on a poll of investment bank trading desks’ bid-offer spreads for RPI swaps and inflation-linked gilts (intra-day) at 10-year, 30-year and 50-year assuming trading £50k risk (IE01)
Source: Columbia Threadneedle Investments
Medians are based at 100% of bid-offer spreads in November 2022. The movements in median, from 100%, indicate outright changes in transaction costs, while the changes in the upper and lower quartiles indicate the dispersion of these costs.
Compared to November, transactions costs in the three months to end-February fell for both RPI swaps and index-linked gilts, across all maturities. RPI swaps priced within a similar or smaller range across all maturities for the same period, whereas in gilts, there was greater price dispersion at 10-year and 50-year. The larger price dispersion, in particular at shorter maturities, reflects the differing gilt stock held by banks and their positioning at that point in time. When a bank facilitates a client’s index-linked gilt purchases, not only do they have to source the bonds to sell, but they often also need to buy short maturity conventional gilts, which continue to trade special (i.e. expensive due to a supply / demand imbalance), to hedge their position. The ease (or lack of) in doing this would reflect as a narrower (or wider) bid-offer spread.
Gilt versus swap inflation
Over December and into the start of 2023, gilt inflation outperformed swap inflation, but this reversed shortly after and persisted all through February.
The cheapness of swap inflation relative to gilt inflation at the end of December / start of January was driven by outright index-linked gilt asset-swap buying from LDI accounts due to the Bank of England’s sell-backs, and high levels of conventional gilt supply, both cheapening up nominal spreads. In the meantime, there were also RPI rebalancing trades which put downward pressure on swap inflation. As buy-out activity restarted after the festive period, index-linked gilts asset-swap selling returned to the market, resulting in swap inflation outperforming gilt inflation, particularly at the 20 to 30-year tenors.
Going forward, if index-linked gilt supply remains light, it could provide a boost to gilt inflation relative to swap inflation. Conversely, if transaction volumes were to pick up, the associated index-linked gilt asset-swap selling by bulk annuity providers would act as a headwind. This is due to the lack of credit-linked inflation supply, hence the inflation exposure sold down via index-linked gilts is often replicated using RPI swaps.
Figure 4: Relative z-spread for generic inflation-linked bonds versus comparator SONIA z-spread (3 months to 28 February 2023 highlighted), where higher (lower) level indicates swap inflation outperforming (underperforming) gilt inflation
Source: Barclays Live
CPI market update
Although there were no publicly announced corporate deals in the three months to end-February, there were some wedge prices quoted in the interdealer market for maturities of 10-years and shorter. Consequently, there was some wedge re-pricing at those tenors.
In recent years, corporate supply has generally comprised of contract for difference-related hedging, which can be up to 20 years, and issuance from utilities firms who hedge their CPI-linked income streams and prefer shorter-dated transactions. Therefore, it is unsurprising that the 10-year point is persistently the tenor where supply is most concentrated, when it does come to market. It marks a point where the trade-off between wearing some curve risk in the hedge and targeting the greatest level of demand may be optimised for the issuer, and is also when RPI reform kicks in.
The forward wedge as at the end of February appears to show the wedge trending to an average of circa 80bps by reform date, following which it drops to an average of circa 25bps. As mentioned in previous quarterlies, the non-zero post-reform forward wedge could be due to flows in the opaque wedge market and the divergence in CPI and CPIH.
Figure 5: Indicative spread between RPI and CPI swaps expressed as a strip of forwards3, at 25 November 2020 (RPI reform announcement), 30 November 2022 and 28 February 2023
Source: Columbia Threadneedle Investments, Morgan Stanley
