A snapshot of the UK inflation market
Supply outlook
Against the backdrop of political and geopolitical risks, the three months to end November saw the UK inflation curve re-price to reflect falling inflation expectations in shorter tenors after months of stickiness. Headline inflation in October took a big step down, falling below expectations. The large decline was primarily due to base effects as the large energy price increase in October 2022 rolled out of the year-on-year index. Many are of the view that interest rates have reached their peak in this cycle with the focus shifting to the timing of rates cuts. Compared to the European Central Bank and US Federal Reserve, the Bank of England is expected by the market to cut rates later and by less. This is a reflection of the higher starting position on inflation as well as ongoing labour market tightness though there is now a clear loosening trend in the form of rising permanent staff availability. This is expected to put cooling pressure on wage growth, in particular for new hires.
The Autumn Statement that Chancellor Hunt delivered on 22 November featured the biggest tax cuts in decades, following which the Debt Management Office (DMO) surprised the market by revising its financing remit down less than expected. This was exacerbated by the DMO electing to cut the amount of short-term bill issuance rather than reducing the sale of gilts. Issuance looks set to remain elevated for what remains of fiscal year 2023/24, as the remit revision brought about a 1% increase to the headline inflation-linked allocation, relative to that previously announced in April. This will be funded by a transfer from the unallocated basket.
At the latest DMO consultation with gilt market participants on 27 November, there was clear support for the launch of a new 30-year bond for the final inflation-linked syndication for this fiscal year, although some requested a delay in the maturity decision in case demand were to change between now and March 2024. The DMO tended to agree with the latter view and has not committed to a specific maturity for its linker syndication. Our view is that a new 30-year bond maturing in 2054 would fill the maturity gap well and generate switch interest, whilst creating a future 30-year benchmark bond. We see the risks skewed to a shorter maturity bond rather than longer particularly given the limited demand for ultra long inflation-linked gilts over the course of 2023.
In any case, Figure 2 shows the projected split by maturity buckets for 2023/24 is being skewed away from maturities of 30-years and longer, which is partially a consequence of the gilt crisis in September/October 2022. Since then, the ongoing narrative has been the absence of LDI demand. In addition, a lower average maturity of gilt issuance makes sense if the DMO were concerned about inundating the market with DV01/IE01, given the elevated level of gross gilt issuance. Gilt inflation has slid lower since then; and the somewhat persistent trend of real yield shortening trades (where longer maturity inflation-linked exposures are reduced and switched into exposures at shorter maturities) and chatter around shortening liability profiles will only weaken market levels further.
Figure 1: Inflation-linked issuance 1
Source: Columbia Threadneedle Investments, DMO, as at November 2023
Figure 2: Distribution of inflation exposure issued, by maturity buckets
Source: Columbia Threadneedle Investments, DMO, as at November 2023
Market liquidity
The usual seasonal effects were at play over the last three months, with market liquidity improving as investors returned after the summer months of July and August. This translated into tighter transaction costs across the board. Transaction costs are expected to widen out again as we head into the festive period.
At the 10, 30 and 50-year tenor points respectively, mean bid-offer spreads2 were 1.0bps, 0.9bps and 1.2bps for RPI swaps; and 1.0bps, 0.9bps and 1.2bps for index-linked gilts. These are multiplicative costs, applicable to the amount of risk (IE01) being traded. Therefore, if you are purchasing £100,000 of 10-year IE01, the dealing charge would be £100,000 (i.e. 1.0bps x £100,000 of IE01).
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 August 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 August, transactions costs in the three months to end-November decreased for both RPI swaps and index-linked gilts, with 50-year RPI swaps and 10-year linkers exhibiting the largest fall. Both instruments also experienced smaller cost dispersion across all maturities, which is to be expected as market liquidity returned amidst the pick-up in activity.
Gilt versus swap inflation
Movements in nominal yields and the bulk purchase annuity (BPA) deal pipeline continued to be the main drivers of the differential between gilt and swap inflation over the three months to end-November. Overall, however, the differential has remained in a fairly stable range.
Swap inflation underperformed gilt inflation at the 20-year tenor, but this was the opposite at the 30-year tenor, where swap inflation significantly outperformed gilt inflation. Issuance events, and in turn, gilt pricing has been the more significant driver of the differential between gilt and swap inflation over the period; particularly as inflation swap volumes have been relatively lower. These issuance auctions created opportunities for buyers from the LDI community and bank treasuries to take advantage of price concession to purchase inflation-linked gilts.
After a record first half of the year for BPA activity, the second half of the year certainly has not disappointed in terms of volume and size of deals. The strong deal pipeline is expected to continue for the remainder of 2023 and into 2024. Over the three months to end-November, there have been instances of relative value flow (switching out of gilt inflation and into swap inflation) suggestive of these deals being hedged by insurers in the market. That said, there is often a timing difference between when deals are made public compared to when they are hedged. To complicate things, the persistent weakness of conventional gilts relative to interest swaps has even led to some insurers switching back into conventional gilts and selling interest rates swaps, triggering some buying of gilt inflation and selling of swap inflation, in other words, the opposite of the default assumption for BPA-related hedging. The uncertainty over timing and direction of hedging flows makes the outlook for the differential between gilt and swap inflation difficult to predict.
Figure 4: Relative z-spread for generic inflation-linked bonds versus comparator SONIA z-spread (3 months to 30 November 2023 highlighted), where higher (lower) level indicates swap inflation outperforming (underperforming) gilt inflation.
Source: Barclays Live
CPI market update
Vattenfall’s decision to stop work on its Norfolk Boreas project and renege on its subsidy contract from the UK government, known as Contract for Difference (CfD,3 ), in the face of rising costs for the industry meant there was little surprise when no offshore wind developers submitted bids in the latest (Allocation Round 5) round of CfD auction. Consequently, the government is set to increase the offshore wind strike price cap in next year’s CfD auction round (Allocation Round 6). This will see the strike price rise from £44 per megawatt-hour to £70-75 per megawatt-hour, i.e. a 60-70% increase. These contracts have been the source of a large amount of CPI risk and hence CPI inflation swap supply. With such a significant rise, there is renewed optimism that this may restore confidence in the offshore wind sector and therefore boost CPI supply to the market.
Over the three months to end November, there were no publicly announced corporate deals, but a plethora of RPI-CPI wedge prices were quoted on the interdealer market at maturities of 15-year and shorter. Consequently, some banks re-priced the wedge at shorter tenors.
Energy prices have been a key driver of the front end of the curve this year, especially through the RPI-CPI spot wedge in Ofgem price cap change months, as RPI has a higher weighting to energy than CPI does. As the price cap has continued to fall over 2023 from elevated levels in 2022, the spot wedge has tightened significantly quarter-on-quarter. Looking ahead, with the energy futures curve flatter, the wedge should widen out once more. But one must note too, the interaction between mortgage rates (as interest rates top out and monetary policy eases, these will fall) and house prices (arriving at some sort of floor) as this will dictate how the wedge evolves.
The Bank of England has set up a special Committee to consider the ONS’ upcoming inflation methodological changes. The two key discussion points were private rents and used cars, where the ONS will use more complete data in their inflation calculations. The changes were deemed to be “fundamental” but not “detrimental” to holders of inflation-linked gilts. Consequent of the changes, we should see a slight bump up in CPI from February 2024 onwards, which should gradually decline over the next year or two.
Figure 5: Indicative spread between RPI and CPI swaps expressed as a strip of forwards4, at 25 November 2020 (RPI reform announcement), 31 August 2023 and 30 November 2023
Source: Columbia Threadneedle Investments, Morgan Stanley
