Supply outlook
Central banks continue to tread carefully when it comes to monetary easing, expressing cautious optimism about inflation yet refusing to commit on the future path of policy rate decisions. Amidst falling inflation and slowing growth, the added complexity of political risk in the US, Europe and the UK has brought greater uncertainty. Even after the European Central Bank (ECB) acted as the first mover to cut policy rates in June, other central banks did not immediately follow in their June meetings. One month on, the most recent Federal Reserve Board (Fed) decision on 31 July was a dovish hold. But the time finally came for the Bank of England (BoE) as the return to normal inflation levels for June was welcomed with the first base rate cut since March 2020, reducing it by 0.25% to 5%. Given the sliver of a majority, there was initially a debate over whether the BoE’s rate cut might have been a mistake, but as weak data out of the US ensued (soft jobs data and sluggish manufacturing data), the conversation shifted to central banks being potentially behind the curve, as economic data releases in the US reignited expectations of faster rate cuts, spurring a sharp global rates rally.
It is possible the outsized market moves may have been exaggerated by the seasonal illiquidity of the summer months, but also reflected that only a modest level of cuts had become priced in so there was much greater scope for forward expectations of policy rates to come down meaningfully in response to incoming economic data. It is worth noting that this was a global reaction to US jobs data disappointing relative to expectations but there is a case to be made for US and UK economic data cycles not being aligned. Unlike the US, UK economic data surprises have been modestly positive and business sentiment has improved post UK election. This is not to say that we expect a reacceleration in wage pressures but the loosening in the labour market will likely slow particularly if improved hiring intentions signalled by business surveys do materialise.
Despite the marginally better economic news, the fiscal position remains challenging. The Autumn Budget is scheduled for 30 October where we should get revised forecasts from the Office of Budget Responsibility (OBR) alongside a revision in financing needs and potentially, gilt issuance. The Labour Party’s new Chancellor, Rachel Reeves, has already acknowledged that tax hikes are likely, particularly considering the £22bn “hole” in public finances. For her first fiscal event, it is likely she will want to show a commitment to reining in the deficit and to avoid significant increases in borrowing to finance pre-existing budgetary commitments. A more modest revision to the gilt remit would likely get adjusted via treasury bills or short and medium dated gilts. We do not expect any impact on the issuance plans for inflation-linked gilts.
Since our last update, the inflation-linked supply event of significance was the 2054 syndication on 9 July, which saw strong demand particularly on switch (as opposed to outright). This was unsurprising as the bond was trading materially cheaper in the secondary market compared to the pricing at its initial launch (+4bps cheaper than the reference bond vs +1.5bps on first issue). The main reason for this yield differential between the 2054 and 2055 bonds was a distortion caused by the idiosyncratic factor of overseas inflation-linked gilt asset swap buying driving outperformance of the 2055 bond.
Calls from investors have been for shorter-dated issuance for the UK Debt Management Office (DMO) to retain optionality given the lack of visibility over pipeline of activity and as pensions scheme demand has waned over the past couple of years. That said, shorter maturity bonds at recent auctions (2033 and 2039 auctions) have been less well received reflecting more tepid demand for shorter dated inflation protection as inflation cools and downside risks emerge. In stark contrast, longer dated (2045 auction and 2054 syndication) supply events have seen strong demand.
The DMO announced the new issuance schedule for Q4 2024 on 30 August. For fiscal year 2024/25, they had originally allocated £9bn of inflation-linked gilt proceeds to syndications and have already used approximately £4.4bn of this for the 2054 deal in July. The recent announcement confirmed that an extra £1.6bn will be transferred from the unallocated pot to the index-linked gilt syndication programme leaving £6.2bn of potential proceeds for the 2 remaining linker syndications of the fiscal year.
Our view remains that the most likely candidate would be a new 15 to 20-year bond – a 2038 or 2043 maturity would work well to plug the obvious gaps in the gilt inflation curve. A new 2035 bond which we previously discussed we see as less likely given the more tepid demand for shorter dated linkers as well as the preference from the DMO to issue shorter linkers via auction rather than syndication. Separately, given the absence of a 2054 in the auction schedule and the choices of 2039 and 2045 instead, this raises the possibility that a 2054 may be selected as the syndication bond of choice in November.
Our base case therefore assumes the next syndication bond to be a re-opening of the 2054 maturity, followed by a new 2038 towards the end of the fiscal year. But we think there is also an equally likely scenario of the new 2038 being syndicated twice starting in late November.
Figure 1: Inflation-linked issuance 1
Source: Columbia Threadneedle Investments, DMO, as at August 2024
Figure 2: Distribution of inflation exposure issued, by maturity buckets
Source: Columbia Threadneedle Investments, DMO, as at August 2024
Market liquidity
Over the three months to end-August, there was initially significant market volatility arising from election/political risk and uncertainty over the timing and size of global monetary easing. Some conclusions were reached by the start of July, with European and UK elections out of the way and the ECB and BoE having both delivered their first base rate cuts. Trade volumes picked up after these risk events, delaying the usual summer window of illiquidity slightly later to the latter half of August.
At the 10, 30 and 50-year tenor points respectively, mean bid-offer spreads2 were 0.9bps, 0.8bps and 1.0bps for RPI swaps; and 0.9bps, 0.7bps and 1.0bps for inflation-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 May 2024. 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 May, transactions costs in the three months to end-August were a mixed bag. These decreased for 50-year RPI swaps and inflation-linked gilts, rose for 30-year RPI swaps and remained unchanged for 10-year RPI swaps and inflation-linked gilts and 30-year inflation-linked gilts. Both instruments experienced similar cost dispersion at 30-year, but was wider at all other maturities, with the exception of 50-year RPI swaps where cost dispersion was smaller. Trading activity was still primarily concentrated at 10 to 30-year maturities but, over the three months to end-August, there was meaningful buying of inflation-linked gilts on asset swap by European insurers, switching activity in the 30-year sector around the 2054 syndication and the return of buyout hedging flows – the interaction between which enabled good two-way flow in both instruments across the curve.
Gilt versus swap inflation
Over the three months to end-August, gilt inflation broadly outperformed swap inflation across the curve. 10-year gilt inflation underperformed swap inflation from end-May until the start of July, driven in part by a less dovish than expected stance of Fed Chair Powell, which caused rates to sell off alongside a rally in oil. But this reversed strongly shortly after, particularly with the subsequent downside surprises to inflation prints and sluggish data releases.
Further out on the curve, there has been a continuation of flows related to inflation-linked repackaged notes that we detailed in our previous update. To recap, these relate to SPIRE, a market-wide special purpose vehicle platform used to repackage risk and sell yield enhancement notes, effectively combining a debt security and a derivative. The attractive yield pick-up of these notes resulted in strong buying of inflation-linked bonds on asset swap by overseas investors, especially European insurers. These notes have been focused in the 20-to-30-year sector. This buying has resulted in long end gilt inflation outperforming swap inflation, even amidst intermittent buyout hedging (selling of inflation-linked gilts, replacing exposure in inflation swaps). There was a short period where noise from the French election at the start of July reversed the weakness in long end swap inflation relative to inflation-linked gilts, seemingly from a pause in the buying of repackaged notes, but this proved temporary and buying resumed after the election.
At the start of August, swap inflation finally recovered from the doldrums, as meaningful buying from bulk annuity providers resurfaced. Other telling factors indicative of such activity were the long-end cross-currency sterling/US dollar basis becoming more negative and long-end gilts cheapening relative to nominal swaps. This tends to arise when insurers switch out of linkers into US-denominated credit swapped back to sterling and sterling inflation swaps.
That said, a general slowdown in activity is characteristic of the summer months. Therefore, we expect less buyout hedging (supportive of long-end gilts compared to swaps). Likewise, the buying of inflation linked-gilt asset swaps by European insurers should slow (supportive of long-end swaps compared to gilts). In aggregate, our view is therefore for the gilt-swap inflation differential to stabilise and trade in a range until September.
Figure 4: Relative z-spread for generic inflation-linked bonds versus comparator SONIA z-spread (3 months to 30 August 2024 highlighted), in basis points, where higher (lower) level indicates swap inflation outperforming (underperforming) gilt inflation
Source: Barclays Live
CPI market update
The UK has experienced a shift of political power and, although this did not shift interest rate expectations, the Labour Party’s green ambitions appear to be greater than those of their predecessor. On renewables in particular, capacity targets across offshore and onshore wind and solar indicate continued support for the Contract for Difference (CfD3)auction programme. The sixth round (AR6) of the UK government’s auction rounds awarding subsidy contracts to support the generation of low carbon electricity has the largest budget of any CfD round yet, at four times the previous round with over £1bn in funding being allocated to these infrastructure projects, and hence it is a round to watch. The market impact could be significant not least in terms of size, but also the fact that allocations are due early September and, with the timing of hedging uncertain anyway, a lack of opportunity to set up trades ahead of the risk coming to market could result in market volatility if CPI supply does surface in September in size. As a recap, CfD hedging flows take the form of swap selling as firms hedge the inflation component of their CPI-linked revenue streams by paying
away CPI inflation. Hedging also tends to be concentrated at the 10 to 15-year point and should therefore support 10-year inflation-linked gilts relative to swaps.
Whilst on the theme of corporate supply, early July saw the Supreme Court rule that water companies could be sued for sewage released into UK waterways. This is a development worth keeping an eye on as any significant legal action could result in increased utility issuance. Separately, the regulator, OFWAT, provided its ruling on Thames Water’s business plan on 11 July and it was not positive. The amount that Thames Water would be able to hike annual customer bills was limited, a decision which negatively impacts its ability to raise capital if it cannot convince prospective investors of the company’s stability without this. To make matters worse, Thames Water was downgraded by ratings agencies Moody’s and S&P to sub-investment grade status at the end of July. The company now faces a heightened probability of ending in publicly funded administration, despite government reluctance.
There are potentially wider reaching market impacts of this downgrade. The consequent widening of credit spreads on Thames Water issued inflation-linked debt and special purpose vehicle repackaged notes that rely on distributions from Thames Water regulated cashflows may lead to additional inflation buying to replace lost inflation sensitivity from the spread widening. This is likely to impact pension funds and insurance companies with direct exposure to Thames Water. Finally, banks that bought inflation bilaterally from Thames Water and sold the exposure to pension funds will also likely need to replace some of that inflation sensitivity.
Unsurprisingly, since the OFWAT determination and credit spread widening at the start of July, RPI swaps outperformed relative to European inflation swaps; and the UK inflation curve steepened as most of the inflation exposure publicly issued by Thames Water is concentrated at 20 to 40-years.
Finally, we note that there was no significant change to pricing of the forward RPI-CPI wedge over the three months to end-August due to limited activity.
Figure 5: Indicative spread between RPI and CPI swaps expressed as a strip of forwards4, at 25 November 2020 (RPI reform announcement), 31 May 2024 and 30 August 2024
Source: Columbia Threadneedle Investments, Morgan Stanley
