In our quarterly LDI Survey we poll investment bank trading desks on the volumes of quarterly hedging transactions. The quarter started positively with policy normalisation and recovery from COVID firmly on the agenda, however, the unconscionable Russian invasion of Ukraine put growth in jeopardy and further galvanised inflation. After a particularly busy fourth quarter, activity fell both in inflation and interest rate hedging, showing a 14% and 35% fall quarter-on-quarter respectively.
2022 commenced with a drive to live ‘with’ COVID as Omicron, whilst highly contagious, proved to be far milder in the vaccinated population. Social restrictions were relaxed across the majority of the developed world (with the exception of some Asian countries, who hadn’t achieved such high coverage of vaccinations or used less effective versions). In the US, UK and Europe monetary policy normalisation came to the fore of the economic agenda, with the expectation of a strong bounce back in economic activity. Inflation has been a persistent concern, particularly in the UK as the annual increase in RPI reached 9.0% in March. However, the world was thrown into chaos by Russia’s invasion of Ukraine. Sanctions quickly followed and expanded nigh on daily to cover an ever-wider group of individuals and companies.
Whilst the Western world has been almost united in condemning the actions and civilian atrocities of Russia, the views of other perhaps more authoritarian states have been more muted with China in particular vetoing UN resolutions. Arms and rhetoric in support of Ukraine have not been in short supply from the West, but NATO and others are walking a tightrope to avoid further escalation. Unsurprisingly the war has further worsened inflationary impacts, particularly in commodities. Russia is a major supplier of energy to Europe and, in fear of economic repercussions, many countries have been slow to block or reduce imports. Additionally, Ukraine is rightly known as the breadbasket of Europe and is a global supplier of wheat and other grains due to its fertile land. In a longer-term impact, Russia is the key supplier of fertiliser across the world, likely resulting in falling yields in the coming months.
Despite these tensions the Monetary Policy Committee (MPC) retained its monetary tightening bent, raising the Base Rate to 0.75% in consecutive meetings. It is widely expected for this tightening to continue, with the Base Rate reaching 1% in the May meeting. Once the Base Rate reached 0.5% the Bank of England (BoE) duly paused passive reinvestments of its Quantitative Easing (QE) assets. All eyes are now on the potential Active Quantitative Tightening (QT), which will be considered once the Base Rate reaches 1%. Fully 70% of our counterparties believe that Active QT will commence in the second half of 2022. If a 1% Base Rate is reached in the May MPC meeting, a consultation is likely to be the first step. Once Active QT has commenced, our counterparties forecast an average reduction of £46 billion per year, targeting a return to pre-COVID balance sheet levels over a few years. Note that estimates ranged from an aggressive £80 billion per year to a more muted £20 billion. Much will depend on the prevailing economic environment, as the BoE would not wish to unwind their position into ‘fragile markets”. It is a similar story in the US with five anticipated rate hikes in 2022. There are even expectations of rate hikes this year in Europe.
Total interest rate liability hedging activity fell to £30.0 billion, a decrease of 35% from the previous quarter, and similarly inflation hedging activity decreased by 14% to £29.4 billion. New hedging activity remained strong, and there were some reductions of LPI-based RPI hedges. The long-awaited nominal curve extension, in the syndication of the new 2073 conventional gilt in February, was unsurprisingly well supported and became more expensive straight after the event, as investors tried to fulfil their desired allocations. Movements in relative value also offered opportunities, particularly around buy-out activity.
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 March 2022
The funding ratio index run by the Pension Protection Fund showed further improvement quarter-on-quarter (107.7% at end December vs 111.4% at end March), helped by rising yields. 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.
Anticipated buy-out activity has been predicted to be in the region of £50 billion per annum over the next few years, which compares favourably with the high watermark of £44 billion seen in 2019.
Market Outlook
Our 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: Change in swap rates over the next quarter.
Source: Columbia Threadneedle Investments. As at 31 March 2022
Unusually our counterparties’ predictions for the first quarter of 2022 for a rise in all three metrics were borne out. The worsening inflationary impacts were outdone by the increase in nominal yields, as UK remained wedded to its monetary tightening cycle and a similar approach in the US. As anticipated the funding remit for 2022/23 was revised downwards – more even than markets had expected – but in absolute terms it is still significant (£124.7 billion) and, without the helping hand of the BoE and its QE programme, this has allowed yields to remain elevated.
For the second quarter of 2022, our counterparties predict a rise in nominal and real yields, albeit with a lower conviction, and are almost evenly split on the expectation for long-term inflation. The background for the expectation of higher yields is driven by the ongoing monetary policy normalisation and a steepening yield curve. This view is further supported by a high level of issuance with no QE backstop. We also expect a reopening of the 2073 nominal gilt to be significant in terms of supply to the market, which may prove hard to digest. In approximate risk terms, supply is due to increase to c. £20 million per month in Q2 versus £5 million per month in Q1. If Active QT commences this quarter, these moves will be further exacerbated. On the other hand, it has been noted that markets are being perhaps too aggressive on the expected path of rate hikes. Currently we have six hikes priced into year-end, reaching 2.165% in the Base Rate. Slowing growth concerns may mean that the MPC will struggle to deliver on this. For those counterparties expecting higher inflation, the Russian war in Ukraine is much cited, particularly in terms of the squeeze in energy prices. For those who believe inflation yields could fall, RPI reform is mentioned, plus the dominant impact of those adjusting LPI hedges downwards.
