A snapshot of the UK inflation market
Supply outlook
The Bank of England’s February Monetary Policy Report (MPR) projects that inflation will fall further by end-2024 to around 2.75%, based on the market-implied path of interest rates. Wholesale energy prices remain an uncertainty given recent geopolitical developments, but the decline in the OFGEM price cap for April to June 2024 has already been embedded into MPR projections – reflecting a fall in headline CPI, which Governor Bailey has reiterated will only be temporary. In fact, the nervousness around cutting interest rates too early is driven by concerns over the persistently tight labour market which could support wage inflation and keep services inflation elevated. Although headline inflation figures for January were lower than expected, with CPI at 4%, this is still double the Bank of England’s target.
2024 will be a year of political and geopolitical uncertainties. 6 March will see Chancellor Hunt deliver the Spring Budget and from the Debt Management Office (DMO), a new gilt remit for fiscal year 2024/25. Both the US and the UK will also be going to the polls. Markets look to have priced in a Conservative Party fiscal giveaway via tax cuts in this Budget, so the bigger risk now is if these have to be significantly scaled back owing to lack of fiscal headroom.
As we approach the end of fiscal year 2023/24, the index-linked gilt syndication in March is not going to be a particularly large event, with only £3bn remaining in the syndication bucket plus the potential for a small upsize using the remainder of the unallocated bucket. The bond has been confirmed as a new 30-year bond maturing in November 2054 which would fill the maturity gap well and generate switch interest out of neighbouring bonds, whilst also creating a future 30-year benchmark bond. The candidates for future index-linked gilt syndications in the next fiscal year are less clear. We expect for the November 2054 to be syndicated one more time but beyond that there is less of an obvious candidate for a new line. Given the structural decline in demand for ultra-long index-linked gilts, in particular from the LDI community, we think the choice of maturity for future index-linked gilt syndications will not extend beyond 2054. This was echoed in the DMO’s annual GEMMs (gilt edged market maker) and investor consultation in January, where there were calls for a reduction in long-end and index-linked gilt issuance in the new fiscal year’s gilt remit.
A new line in the 15 to 20-year sector is a possibility, as the 2039 bond will soon be at benchmark size. The recent 2039 auction was well attended by dealers as they attempted to cover short positions reflecting prior client demand for the bond. That said, newer issues have a higher coupon and have been less popular, and with this area of the curve already crowded, it would mean issuing a new bond maturing in the same year as an existing bond, which the DMO may be reticent to do.
Figure 1: Inflation-linked issuance 1
Source: Columbia Threadneedle Investments, DMO, as at February 2024
Figure 2: Distribution of inflation exposure issued, by maturity buckets
Source: Columbia Threadneedle Investments, DMO, as at February 2024
Market liquidity
Liquidity picked up significantly over the back end of November and into the first week of December as market participants rushed to get their end-of-year hedging requirements implemented ahead of liquidity winding down after the final supply event of the year, as banks balanced their books going into the festive period. Liquidity swiftly returned to the market in the new year as there was heavy issuance in the first week of 2024.
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)
RPI swaps
Inflation-linked gilts
Source: Columbia Threadneedle Investments
Medians are based at 100% of bid-offer spreads in November 2023. 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 decreased for both RPI swaps and index-linked gilts, across all maturities. Both instruments experienced smaller cost dispersion at the 10 and 50-year points. Without the return of LDI demand, trading activity has been more concentrated at sub-30-year maturities relative to longer maturities.
Gilt versus swap inflation
Over the three months to the end of February, relative value volatility was observed in the front end as market participants positioned themselves in response to realised inflation falling faster than anticipated. Macro developments aside, the differential between gilt and swap inflation at sub-10-year maturities was also driven by cheapening of conventional gilts in this sector. Despite quantitative tightening, these remain in high demand and trade at a premium (i.e. they trade “special”), as they are locked up on the Bank of England’s balance sheet, albeit these special gilts have become less special in recent months. Consequently, this gave rise to opportunities to switch from gilt to swap inflation hedging below the 10-year maturity point.
In contrast, longer-dated inflation relative value volatility remained relatively muted over this period. After the 30-year auction on 8 November 2023, there was no long-dated inflation-linked gilt supply until 30 January 2024. This provided support for longer-dated gilt inflation relative to swap inflation over this period. Since then, the prevailing theme has reverted to that of “unloved ultras”. Insurers typically sell down index-linked gilts that they receive from pension schemes and replace this exposure with RPI swaps, causing gilt inflation to underperform swap inflation. As bulk purchase annuity (BPA) volumes continue to rise, it may be possible to see growing demand for index-linked gilts from insurance clients competing for assets, due to lack of inflation-linked corporate issuance. If this realises, there may be scope for long-end inflation expectations to recover, to an extent where gilt inflation outperforms swap inflation.
Figure 4: Relative z-spread for generic inflation-linked bonds versus comparator SONIA z-spread (3 months to 29 February 2024 highlighted), where higher (lower) level indicates swap inflation outperforming (underperforming) gilt inflation.
Source: Barclays Live
CPI market update
The UK government’s auction rounds awarding subsidy contracts, known as Contract for Difference (CfD3), have recently come back into the limelight. After the 2023 round (AR5) saw no offshore wind developers submit bids as they felt the level of government support was too low in the face of rising costs, the strike price cap for the CfD round for 2024 (AR6) will see the maximum strike price raised by 66%. Despite this, the UK’s largest electricity producer, RWE warned that government forecasts for wholesale power prices and windfarms’ performance could still risk overestimating the cost to bill payers and hence lead to fewer offshore wind contracts being awarded. With government forecasts not yet released, these concerns may still lead to a further review of the strike price cap.
A higher strike price should attract more bids and in turn the need to hedge the inflation component of firms’ CPI-linked revenue streams by paying away CPI inflation. At the same time, this could restore confidence in the offshore wind sector and boost CPI supply to the market.
One must note however, that as CPI swaps are less liquid and have a strong correlation with RPI, the paying away of CPI inflation may also be done via RPI swaps. Corporates tend to be payers of bilateral inflation swaps, so a successful CfD auction round may see a surge in bilateral RPI swap paying, which could widen out the LCH cleared-bilateral inflation basis. The imbalance between cleared and bilateral pricing may lead to investment banks offering more competitive prices for bilateral RPI inflation receiver swaps to balance out their books, widening the basis.
That said, there are other factors to consider here. Firstly, even if pension funds and insurers had the opportunity to increase bilateral inflation exposure against the trend to clear swap trades, the size is unlikely to be sufficient to tighten the basis. Secondly, insurers are currently temporarily more highly allocated to index-linked gilts, but their end state is more likely to be a combination of credit and RPI inflation receiver swaps, the latter of which they tend to access bilaterally, so this could offset any basis widening. Finally, ongoing concerns over elevated leverage across water companies may limit further debt issuance until credit metrics stabilise, in turn reducing the supply of CPI-linked exposure from the sector and hence reduce hedging requirements.
In our previous update, we highlighted the importance of the interaction between mortgage rates and house prices in dictating how the RPI-CPI wedge evolves going forward. With the rate hiking cycle much behind us, mortgage rates have fallen to reflect market expectation of rate cuts being delivered, hence working in the direction of narrowing the wedge. A more meaningful decline in interest rates could cause the “Mortgage Interest Payments” (MIPS) contribution to go negative in the coming years. MIPS currently contributes approximately 120 bps to the wedge so this may be at least partly reduced. As for house prices, forecasts are mixed, but most are expecting house prices to recover over 2024 – a sustained improvement in the outlook for house prices would exert widening pressure on the wedge.
Figure 5: Indicative spread between RPI and CPI swaps expressed as a strip of forwards4, at 25 November 2020 (RPI reform announcement), 30 November 2023 and 29 February 2024.
Source: Columbia Threadneedle Investments, Morgan Stanley
