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Repo rates are expressed relative to SONIA, and the chart below displays the average repo rates that we have achieved over the past four quarters for three, six, nine and 12-month repos, shown as a spread to average SONIA levels at the time. The volatility and market uncertainty that resulted from the mini-Budget also weighed upon funding markets, particularly for shorter dated trades as can be seen from the achieved spreads below. Note that during the fourth quarter of 2022 no repos were traded with a 12m tenor so the chart reflects the previous quarter’s value.
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Themes
The secondary impact of the mini-Budget crisis centred around collateral and the velocity of movement; rather than a lack of balance sheet for repo funding (a la March 2020). Yet, the difficulties around collateral substitutions and settlements did in many cases prompt a review by individual banks’ credit officers, resulting in a temporary reduction or hiatus in repo balance sheet provision in some cases. Once these reviews were completed balance sheet availability opened up again – some with the addition of haircuts to provide additional protection to the bank. Of course, the momentous lack of certainty in the future path of interest rates also impacted the typical repo spread to SONIA as trading a fixed rate forced the banks to take a conservative view on where yields could reach.
All data and sources Columbia Threadneedle Management Limited, as at 30 June 2024 and Valid to: 30 September 2024
Regions
Political and monetary policy uncertainty weighed upon markets in the fourth quarter of 2024, with multiple ‘live’ central bank meetings creating binary risk and political regime change for France, Germany, and vitally, the US
Consequently, market activity was muted and with less appetite for banks to warehouse risk, even relatively small amounts of activity contributed to significant market moves.
In the UK, Chancellor Rachel Reeves announced a Budget fixated on fiscal rectitude; whilst tax and spending increases featured to boost productivity, she instigated strict fiscal rules which, if breached, would dial down spending (raising tax or borrowing were both ruled out as options). These rules did not provide much headroom, with the result that higher yields (thus increasing the cost of borrowing) could wipe out the fiscal space, necessitating either a change to the rules or a reduction in spending. To expunge the spectre of the short-lived and profligate Truss Government, it is possible that the Chancellor created rules that were too strict and thus will hamstring key spending commitments designed to support election pledges to raise productivity and investment. Whilst the UK struggles with stringent requirements the opposite is true of other major economies. In France, Prime Minister Barnier’s brief government collapsed in a modest attempt to rein in debt growth, and the German government also fell whilst trying to loosen the debt brake and permit more spending. President Trump was long on promises and short on details in his campaign, but it is likely that his pledges (if enacted) will greatly increase government debt, resulting in a consideration of whether such debt levels are both sustainable and desirable. It is the US that led the global rout in bonds, resulting in significantly higher yields into year end, but similar debt burdens and questions over economic growth particularly in the face of arbitrary US-led tariffs in other developed countries stymied their desire to withstand the global phenomenon. From an LDI perspective, the rising yield environment is both a test and a positive reflection of the hard work asset managers and clients have enacted to define their collateral waterfalls and therefore responsiveness to market moves as markets remained orderly at all times.
Total interest rate liability hedging activity declined to £21.2 billion, whilst inflation hedging also fell to £26.8 billion. Outright hedging activity was a factor over the fourth quarter of 2024 but generally in small size and direction-specific to individual client requirements. The constant grind cheaper of UK government bonds versus swaps resulted in relative value activity in its traditional forms and also more balance sheet centred trade activity such as forward gilts, linker asset swaps with upfront payments and a continuation of SPIRE activity – buying index-linked gilts on asset swap. This balance sheet intensive trade activity has largely been led by insurance companies, reflecting an opportunity and a lack of alternative assets. However, the structure of these in terms of being bilateral and typically on a multi-currency corporate bond collateral annexe will mean that not only are these expensive to enter into, but they will also likely be prohibitive to exit, resulting in these becoming fixed assets until maturity or buy and hold. This reduces the flexibility of such asset types to respond to significant changes in relative value, potentially allowing gilts more room to outperform in future before profit-taking opposes that move.
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 (or removal) of counterparties in 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 December 2024
The funding ratio index published by the Pension Protection Fund has adjusted their roll-forward calculation methodology which estimates the funding ratios of schemes. This has resulted in a downward adjustment to funding ratios as in particular the roll-forward of asset values has decreased. The new methodology showed a slight increase in funding levels quarter-on-quarter (125.7% at end December vs 123.5% at end September) reflecting the higher yields discussed above, benefitting those who are not fully hedged (the change is likely modest due to high hedging levels within the UK defined benefit (DB) universe).
Market Outlook
We also asked investment bank derivatives trading desks for their opinions on the likely direction of key rates for liability hedging. The aim is to get information from those closest to the market to aid investors 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 December 2024
Last quarter our counterparties expected all three metrics to fall, but with little confidence in inflation. Unfortunately, that was the only correct prediction. As nominal yields rose, they dragged up real yields in turn, because of the global question over debt sustainability reflected in higher yields – increasing governments’ borrowing costs. It should also be noted that the purported LDI demand that in previous years has dominated in the fourth quarter failed to materialise in significant size.
Our counterparties predict a fall in both nominal and real yields to the end of the first quarter of 2025 and a rise in inflation costs. Generally, the sense of lower yields is a reflection upon the high starting point at the end of 2024 driven by the global bond sell-off, and factoring in the expected continuation of the monetary policy cutting cycle. Whilst its speed and extent in 2025 remains uncertain, it is expected that the February meeting at least will see action on that front. Our counterparties consider how much of the ‘bad news’ of high debt levels and low growth is priced in already and believe that the majority is, barring changes on a global front (read tariffs!). The UK appears relatively stable from a political standpoint versus key European nations and the US, which may make it a safe haven for assets; which combined with the shorter tilt in gilt issuance should be positive for longer tenors. Risks to the expectation of lower yields centre on global factors such as further loosening in US fiscal policy (more than is priced into markets), stimulus measures in China which could push inflation and yields up, the ever present oil contagion and cost issue, or more locally, fallout from constraints on UK fiscal policy resulting in higher taxes or borrowing if spending is not reduced. However, the scale of the expected decrease in yields is anticipated to be limited, bringing risks to the view, this largely because of the global repricing of yields around fiscal rectitude and projected stimulus. For inflation, uncertainty around the out-turn of the UK Budget and its inflationary impacts (not forgetting the above inflation pay rises meted out to public sector workers), in particular the rise in employers’ national insurance could lead to higher long term inflation swap levels. External factors such as oil and gas prices could also exert upward pressure. Risks to this view are around strong inflation-linked issuance anticipated from the corporate sector which coupled with inflation selling from systematic participants could belie the rising expectations.
If you would like to learn more about any of the topics discussed, please contact your client director.