Beyond RPI reform - inflation market update - BMO Global ...
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For Professional Clients and/or Qualified Investors only
Beyond RPI reform
– inflation market update
January 2021
Why did gilt inflation move higher post reform announcement?
The price action immediately following the reform announcement confounded
expectations that gilt inflation should move lower once the reform was confirmed
for 2030.
A useful parallel is the 2016 Brexit vote. When the result was announced people
Nabil Owadally clearly understood that there would-be long-term ramifications, but nothing really
Investment Solutions changed in their immediate circumstances.
Portfolio Manager
In the same way with the RPI reform announcement, the backdrop for UK pension
funds is arguably unchanged i.e. that the majority have still not fully hedged their
Contact us inflation risks and, at best, the period of reform uncertainty just delayed their
hedging plans.
Institutional business: Given that the UK Debt Management Office (DMO) had been issuing far fewer index-
linked gilts since the initial reform announcement in September 2019, an instantaneous
+44 (0)20 7011 4444
increase in the demand for inflation without a commensurate reaction on the supply
institutional.enquiries side of the equation led to an imbalance of market flows.
@bmogam.com
As we alluded to in our previous note, those who had delayed their inflation hedging
bmogam.com in anticipation of better market levels were faced with a dilemma of whether to play
the long game and hope for better levels, or to lock in the marginal fall in inflation
expectations since the original September 2019 announcement. Several investors took
Telephone calls may be recorded. the risk averse decision to hedge following the announcement, which also sparked the
active investment community, who had sold inflation going into the reform decision, to
close out their positions for fear of further losses.
All the above factors, combined with a dealer community that had a limited stock of
index-linked gilts to offer owing to limited supply from the DMO, led to a perfect storm
for the market.
Key Risks
Capital is at risk. The value of investments and the income derived from them can
go down as well as up as a result of market or currency movements and investors
may not get back the original amount invested.
Past performance should not be seen as an indication of future performance. The
performance figures are shown gross of fees. The effect of fees or costs will be to
lower the figures shown.
Continued
Page 2
BMO alongside other investors and gilt dealers reached out We focus on three of these forwards, the 5-year swap rate 5 years’
to the DMO to address this market squeeze. The DMO has the forward (5y5y), the 10-year swap rate 10 years’ forward (10y10y)
flexibility to respond to these situations by using their tender and the 10-year swap rate 20 years’ forward (20y10y).
programme and took on board market feedback to schedule
To compute this over time, we assume a historical wedge of
a tender of the 2048 index-linked gilt on the 9th December.
0.90% across all tenors until 4th September 2019. After this date,
Although the size of tenders are smaller than auctions, this
we assume it remains 0.90% for the first 10 years then zero
helped bring some balance to the market with long dated
thereafter, in line with the RPI reform result. We know the market
gilt inflation stabilising after the frenzied activity of the week
did not instantaneously price RPI alignment with CPIH on the 4th
following the reform announcement.
September 2019, but it does allow us to assess pricing beyond
this date considering the new regime. This also assumes that
Where to from here for the inflation market? the current decision will not be reversed before 2030, again an
assumption which we are comfortable making given the strength
To dig deeper into what current market valuations are telling us,
of the statement from the Chancellor.
we decompose the RPI swap curve into a series of continuous
forwards. We have used the RPI swap curve here as it is
more granular and less affected by distortions than the gilt
5y5y inflation risk premium (5y5y RPI forward minus BoE
inflation curve.
target + wedge)
The chart below compares the RPI forwards (blue line, left-hand
axis) to the Bank of England 2% CPI target, adjusted by the RPI- 0.8
CPI wedge using a fair value estimate of 0.90% until February 0.6
2030, then zero beyond (orange line, left-hand axis). The grey
bars show the difference between the two measures as a proxy 0.4
for the inflation risk premium (right-hand axis). 0.2
0.0
RPI forwards vs. Bank of England target + expected wedge -0.2
4.0% 1.4% -0.4
3.8% Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Dec-17 Dec-18 Dec-19
1.2%
3.6%
3.4% 1.0% 5y5y 5y5y average 2010-2019
3.2% 0.8%
3.0% Source: BMO Global Asset Management and Bloomberg as at 09-Dec-20
2.8% 0.6%
2.6% 0.4%
2.4%
2.2%
0.2% The inflation risk premium in the 5y5y forward (shaded blue area)
2.0% 0.0% has been particularly significant and persistent since 2018 when it
became clear that the UK would not be pursuing close alignment
1y
1y1y
2y1y
3y1y
4y1y
5y1y
6y1y
7y1y
8y1y
9y1y
10y2y
12y3y
15y5y
20y5y
25y5y
30y5y
35y5y
40y5y
45y5y
with the EU in its future trading relationship. We can speculate
Difference RPI forwards BoE target + wedge on the precise reasons for this elevated inflation risk premium,
perhaps an expectation of lower post Brexit productivity due to
Source: BMO Global Asset Management and Bloomberg as at 11-Dec-20
less integrated supply chains and a less flexible labour market
resulting from lower labour supply from the EU. Clearly investors
From this we can infer a few things are willing to buy short dated inflation linked assets as a hedge
against this risk and are yet to unwind these hedges. We have
• The RPI swap curve is pricing in a step change in inflation
however reached the crunch point in Brexit negotiations on the
expectations beyond 2030, reflecting the expected alignment
future relationship so we can expect some of these hedges to be
of RPI methodology with CPIH
reassessed considering the outcome. If a no-deal Brexit does not
• RPI forwards nonetheless retain a meaningful premium materialise, then a tail inflation scenario should be far less likely,
to the BoE’s inflation target, though this is not uniform which should in turn lead to a partial unwind of these positions
across the curve reflecting varying investor preferences at and a normalisation of this risk premium perhaps closer to the
different tenors historical average (orange line).
However, looking at this inflation risk premium in isolation Another factor influencing the inflation market is the government
tells us little about the future direction of travel, we can better policy on climate change. One possibility is that the Prime
infer this by comparing how this risk premium has behaved Minister Boris Johnson could choose not to go down the Contracts
over time. for Differences route and instead focus his efforts on selling
Continued
Page 3
off new wind infrastructure directly to insurers. As part 20y10y inflation risk premium (20y10y RPI forward minus
of the Government’s recent review of Solvency II capital BoE target + wedge)
requirements, insurers could benefit from a reduction in
capital requirements, and there is also encouragement 1.4
for greater investment in infrastructure. This neatly ties in 1.2
with the Government’s climate change goals. Furthermore, 1.0
as insurers have long-dated illiquid liabilities, long-dated 0.8
illiquid assets such as these seem a natural match. In this
0.6
scenario, however, the likelihood of CPI supply coming to
0.4
market is diminished.
0.2
0.0
10y10y inflation risk premium (10y10y RPI forward minus
-0.2
BoE target + wedge) Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Dec-17 Dec-18 Dec-19
20y10y 20y10y average 2010-2019
1.4
Source: BMO Global Asset Management and Bloomberg as at 09-Dec-20
1.2
1.0 The 20y10y forward is the one of the points on the curve with
a lower inflation risk premium. One of the contributing factors
0.8 is likely the shift shorter in pension fund demand, exacerbated
by those pension funds that chose to underweight the long
0.6 end which was perceived as more vulnerable to RPI reform. We
should see some of this exposure shift back now that reform
0.4 has been confirmed, though perhaps pension funds may wait
for the DMO to start supplying longer duration index-linked gilts
0.2
before doing so. On balance, we see this part of the curve as
having less scope to reprice lower as starting valuations are less
0.0
Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Dec-17 Dec-18 Dec-19
demanding and supply and demand should be better aligned.
10y10y 10y10y average 2010-2019 In the final section, we dig a bit deeper into the expected drivers
of the inflation demand and supply over the coming year.
Source: BMO Global Asset Management and Bloomberg as at 09-Dec-20
Demand from pension funds to pick up in 2021
The 10y10y forward is one of the points with the largest Demand should pick up in 2021 from the implementation of
inflation risk premium. This can be ascribed to the shift shorter delayed hedging plans and technical factors. Gauging with
in inflation demand from pension funds over the past few precision what proportion of hedging has been delayed is
years with this demand largely outstripping supply from the difficult but anecdotally we would note that hedging activity
DMO. Equally, the 10 to 20-year maturity tends to be popular has not been completely absent during 2020. In particular, those
for index-linked corporate issuance, which has been much schemes whose sponsor covenants weakened as a result of the
quieter than usual this year. We should see a pick-up in both COVID-19 shock have been more active as they could not afford
DMO and corporate issuance next year, however, this needs to delay their de-risking plans.
to be balanced against additional pension fund demand. The
The technical factors relate primarily to the recalibration of
most obvious parallel was in the aftermath of the CPAC 2012
actuarial assumptions which may lead to increased inflation
(Consumer Prices Advisory Committee) inflation consultation
demand. Firstly, most actuaries are yet to update their RPI-CPI
announcement where the removal of the uncertainty unlocked
wedge assumptions which still reflect pre-reform historical
significant amounts of inflation hedging activity. This in turn led
averages. This will impact CPI liabilities where valuations are
to an overshoot of market levels relative to historical inflation
typically inferred from RPI market valuations, then adjusted by
risk premia as demand outstripped supply.
an assumed RPI-CPI wedge. Assumptions are expected to shift
This gives us some comfort that a resumption of inflation supply to the use of a historical average until February 2030 then a
should see some normalisation in the inflation risk premium number closer to zero beyond this date. All else being equal this
in this part of the curve, though as 2013 showed, it can take a should increase the value of CPI liabilities which should in turn
while for the market to digest the additional demand and to increase their inflation sensitivity, requiring increases in inflation
return to some form of balance. hedging to offset this.
Continued
Page 4
The flexibility to apply CPI increases instead of RPI in private A less volatile RPI beyond 2030 should mean both inflation caps
sector pensions affected mostly statutory minimum increases and floors will decline in value which should, all else being
relating to pensions in payment and the revaluation of deferred equal, increase the inflation sensitivity of LPI linked liabilities.
pensions. As a result, most CPI exposure tends to be shorter The 0% floor is most vulnerable to a repricing as its starting level
than RPI, typically in maturities less than 25 years. As a result, of volatility is much more elevated than that of caps due to the
the impact of the wedge recalibration should be more muted imbalance of market flows i.e. dealers are generally short the
as it should only affect those CPI linked liabilities beyond 2030 0% floor having sold floored LPI structures to pension funds.
which are a fraction of an already smaller subset of the total Furthermore, as we alluded to above, the occurrences of negative
pension liabilities. CPIH year on year realisations are much lower than in RPI which
should mean a lower value for 0% RPI floors after 2030. However,
Another potential change could arise from the recalibration of
these changes are unlikely to be instantaneous and are reliant on
cap and floor pricing now that RPI will be realigned with CPIH
the modelling approach from actuaries who may take a different
beyond 2030. From a bottom-up perspective, the distribution of
view or may take the lead from dealers’ LPI quotes, which may
CPIH is inherently different to that of RPI, it is less volatile and
not fully reflect the fair value change given existing positioning on
less fat tailed. This is mostly down to compositional differences
their trading books.
as RPI contains a larger weighting to volatile energy prices
as well as including mortgage interest payments (MIPS) and Furthermore, given the typical triennial valuation cycles, these
house prices, which are not in CPIH. For example, when the effects will take time to filter through and will all not occur at the
BoE cut rates aggressively in 2008-09, this was enough to take same time. Furthermore, there may be other changes such as,
RPI into negative territory, driven by the MIPS component for example, to longevity assumptions post COVID and the pricing
given the prevalence of floating rate mortgages at the time. By of member options such as transfer values and pension increase
comparison, CPIH over the same period did not fall below 1% as exchanges as a result of RPI reform.
consumer prices did not experience deflation. We can see this in
a histogram of year on year changes in RPI and CPIH dating back
Supply from DMO to increase meaningfully in 2021
to 1992 when the BoE first started to base monetary policy on
an explicit numerical target for inflation. The period spanning the announcement of the government’s
intention to consult on RPI reform on 4th September 2019 to
the announcement of its decision on 25th November 2020 was
characterised by a smaller proportion of the gross gilt remit being
allocated to index-linked gilts and, those bonds that were issued,
RPI year on year changes 1992 to 2020
were shorter dated than the historical average.
Some of this was by design as the Office Budget Responsibility
(OBR) highlighted in its July 2017 fiscal risks report that continuing
to issue over 20% of gross gilt issuance in longer duration
index-linked gilts would put the proportion of index-linked debt
on an unsustainable path, and leave the government finances
susceptible to periods of higher inflation.
Future index-linked debt stock under different issuance
Source: Bloomberg as at 09-Dec-20 assumptions
CPIH year on year changes 1992 to 2020
Source: Bloomberg as at 09-Dec-20 Source: DMO calculations
ContinuedPage 5
This fiscal year has helped stabilise this proportion, as less Now some of this is playing catch-up given the lack of longer
than 7% of the record £485.5bn of gilt issuance would have dated index-linked issuance over the past 12 months but it’s fair
come from index-linked gilts. The DMO has been clear in to assume that the average duration for future issuance will be
its statements that it is committed to the index-linked higher than the 2020 average.
market and now that reform uncertainty is out of the way,
Assuming a 15% allocation to index-linked gilts for the next
we should expect more “normal” levels of index-linked
fiscal year would see issuance of close to £37bn. If we assume
issuance. However, it’s unlikely we will see a return to
the index-linked gilts issued have an average duration of 20
previous years of over 20% of the gilt remit being allocated
years, this would mean £74m of inflation risk (IE01) being
to index-linked gilts.
supplied to the market. Added to the £22m of IE01 in Q1 2021,
The remaining quarter of the current fiscal year gives us this would take the total over the next 15 months to £96m of
a guide to what lies ahead. As shown the chart below, IE01, this compares with approximately £57m of IE01 for the
over Q1 2021, the inflation risk (IE01) issued by the DMO previous 15 months, representing an almost 70% increase
is estimated to be 60% of the entire issuance over the in supply.
previous 3 quarters. This is primarily achieved by using
In addition, reduction in RPI reform uncertainty, improved
longer duration index-linked gilts with an expected
clarity in the regulatory pricing framework for utilities, tighter
average duration of 26 years over Q1 2021 compared to
credit spreads and elevated inflation risk premia in the 10 to
approximately 15 years for the 9 months prior.
20-year maturity range should all provide improved incentives
for corporates to issue inflation-linked debt.
It is difficult to predict the precise interaction of the
Inflation risk issued by maturity buckets
demand and supply but the extent to which inflation risk
25,000,000 premia will normalise over 2021 will be largely a function of
Period of reform uncertainty the degree of pent up demand from end investors and the
20,000,000 post Brexit landscape, which matters to a greater extent for
the shorter maturities.
15,000,000
Either way, 2021 will be an important year for the UK inflation
10,000,000 market considering that over the past 15 months it has been
a shadow of its former self in terms of its depth and ability
5,000,000
to facilitate significant risk transfers. Investors, dealers and
- issuers will all hope that this episode can be consigned to
Q2 2019 Q3 2019 Q4 2019 Q1 2020 Q2 2020 Q3 2020 Q4 2020 Q1 2021 history and although the reform did not go the way many
0-10 10-20 20+ investors hoped, at least the uncertainty has been lifted which
can only be a good thing for all those that participate in the
Source: BMO Global Asset Management and DMO as at 10-Dec-20 inflation market.
The views and opinions expressed in this article by the author do not necessarily represent those of BMO Global Asset Management.
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