In line with most economists’ expectations, the Bank of England held the UK base rate today for the fifth consecutive occasion at 5.25%. It is universally acknowledged that, barring some unforeseen geopolitical crisis or fiscal surprise, we are at the peak of base rates in the UK for this cycle, meaning that what has gone up will now start coming down. This is supported by the changing sentiment within the Monetary Policy Committee. At the previous February meeting two members voted to hike rates to 5.5%, 6 voted for no change and one voted for a cut. Today’s announcement had the same member voting for a cut and the other 8 members voting to hold. On the face of it this would appear to be a dovish outcome (skewed towards less restrictive policy) but the commentary from the Bank was arguably more neutral. The press conference cited slower progress than would have been liked on wages, and although the Bank expects inflation to fall to around 2% in the coming months it emphasised its focus on the sustainability of lower inflation.
The market read the vote split as dovish, and longer dated gilt yields initially fell slightly, before rising again in sympathy to events elsewhere in the world, most likely a mild jobless claims data point in the US. The big questions are when and how fast will monetary policy become more accommodative, and has the market priced it right? The market is now pricing a 75% chance of a cut in June, 1.5 cuts by August and largely a cut at every meeting thereafter. The next MPC meeting is scheduled for 9 May.
Broadly speaking, our house view assigns some probability to the Bank cutting rates somewhat further and/or faster than is priced in, as we believe that UK inflation is likely to fall substantially, not least because of technical factors such as the energy price cap. Other anecdotal evidence can be seen in used car prices, which were down 7% in January from a year previously. This would put downward pressure on longer dated yields, which reflect the market’s expected path for shorter term rates over the relevant time horizon. There is also the possibility of the US Federal Reserve and European Central Bank cutting in June, which would put further pressure on the Bank of England to follow suit. The most obvious risk to this view is that wage data could remain sticky. Additionally, there had been some concern that the Government would deliver an inflationary Budget at the beginning of March with significant fiscal giveaways, but a somewhat empty Treasury piggy bank meant that this was not a dial-moving event. We expect a second fiscal event later in the summer, before an anticipated election in November, which may still result in inflationary tax breaks, as the available headroom for such measures fluctuates week on week.
What does this mean for LDI strategy?
Firstly, we would reiterate that LDI is a risk management tool, so market timing should be a secondary consideration. However, if considering the market environment, you want interest rates to be as high as possible when hedging. You must look back more than 12 years to find a period where long-dated UK yields were as high as they are currently, making this a historically attractive time to consider liability hedging. Coupled with improved funding ratios, we are seeing most pension scheme clients seek to close out all, or the majority of, any under-hedge that may exist in their LDI strategy, locking in a strong funding position and taking advantage of attractive yields
