Purported and temporary ceasefires and the ongoing depletion of inventories kept the focus on the Strait of Hormuz. Hopes were raised with a Memorandum of Understanding creating a partial reopening in mid-June, however fiery rhetoric and ceasefire breaches soon prevented a sustained increase in shipping leaving many ships stranded. The uncertainty and ultimate lack of progress has caused volatility in oil and thus rate change expectations from day-to-day, as the binary nature of the closure of the Strait complicates projections for central banks. Meanwhile in the UK a new Prime Minister was anointed, bringing a change in policy tone yet with the same fiscal constraints, potentially limiting space to manoeuvre.
If this sounds like a broken record that is because it is – the Strait of Hormuz has dominated global headlines since the end of February with no resolution in sight, albeit with a brief fillip for markets during the Memorandum of Understanding in mid-June until that fragile ceasefire failed to hold. Volatility in oil prices is now the new normal, responding with alacrity to each rumour of closure or reopening of the Strait. Analysts believe that the pressure on oil prices should be much higher than is playing out in markets and consider China to be the saviour through reducing imports substantially and drawing down inventories and decreasing usage. However, a word of caution is that this state of affairs cannot continue indefinitely, particularly as Iran proxies attack alternative oil shipping routes. The continued pressure on oil and other production inputs is taking its toll on global economies but with an uneven impact – Europe has been particularly vulnerable and is showing early signs of stagflationary risks despite the EUR11bn of fiscal measures to cushion the effect. As a consequence, the ECB chose to hike the base rate to provide an early counter – this can be seen versus an ‘active’ hold in the UK and no change in the US despite the new Fed Chair Kevin Warsh taking the helm.
If this sounds like a broken record that is because it is – the Strait of Hormuz has dominated global headlines since the end of February with no resolution in sight, albeit with a brief fillip for markets during the Memorandum of Understanding in mid-June until that fragile ceasefire failed to hold. Volatility in oil prices is now the new normal, responding with alacrity to each rumour of closure or reopening of the Strait. Analysts believe that the pressure on oil prices should be much higher than is playing out in markets and consider China to be the saviour through reducing imports substantially and drawing down inventories and decreasing usage. However, a word of caution is that this state of affairs cannot continue indefinitely, particularly as Iran proxies attack alternative oil shipping routes. The continued pressure on oil and other production inputs is taking its toll on global economies but with an uneven impact – Europe has been particularly vulnerable and is showing early signs of stagflationary risks despite the EUR11bn of fiscal measures to cushion the effect. As a consequence, the ECB chose to hike the base rate to provide an early counter – this can be seen versus an ‘active’ hold in the UK and no change in the US despite the new Fed Chair Kevin Warsh taking the helm.
Closer to home the UK always has time for some politics. The much-anticipated drubbing that Labour received in the May local elections accelerated the demise of Prime Minister Keir Starmer. Indeed, within a month the new Prime Minister Andy Burnham transitioned from Mayor of Greater Manchester to be elected as an MP and then elevated uncontested to Prime Minister. Previous comments about being ‘in hock to the bond markets’ led to some nervousness in markets but since taking the role his rhetoric has been far more conciliatory. This is despite clear signs that the new PM has an agenda which will cost money; support for struggling households and pubs, higher defence spending and welfare reform. Few would argue that these are not admirable goals, but the question is how he and the new Chancellor John Healey will pay for them. At present the Government have committed to maintaining the current fiscal rules (with some wiggle room on investment) and to the Labour manifesto of the last election, yet there are some signals that that may change. The bond market vigilantes appear to be in wait and see mode until the Autumn Budget scheduled for the 28th October.
In the meantime, the Debt Management Office (DMO) and Bank of England (BoE) have been making hay while the sun shines. The DMO continues its innovative journey suggesting dual tranche and switch auctions and the market welcomed the news that they are committing to expanding T-bill issuance and enhancing liquidity within that market through a standing repo facility. The trend of shortening issuance so as not to cause distress at the longer tenors has persisted throughout the second quarter, supporting the market in the face of political uncertainty. From a weighted average maturity high in 2000 of 30yrs, the WAM has now fallen below 10yrs. The fact that at the start of the year multiple rate cuts were priced into the market has been a boon for the BoE as they can provide a tightening aspect to the market without changing the Bank Rate – an ‘active’ hold. Market expectations around rate hikes and the number and speed is almost entirely dependent on news-flow regarding the Strait of Hormuz. The BoE have increased their scrutiny on the functioning of markets with particular focus on the repo market; this is especially important as the direction of travel is to use repo as the marginal monetary policy tool. Despite a negative reaction to the consultation, it seems clear that the direction of travel is towards action to reduce leverage, focused on leveraged hedge fund strategies which could cause market disruption when unwound rapidly. From a pure ecosystem perspective, it appears more likely that some form of mandatory minimum haircut could be required, with the devil being in the detail – who is impacted, what level they are set at, whether at portfolio or trade level, etc. The long-awaited Financial Stability Report was also released by the BoE. This contained the hoped-for consultation on easing of leverage ratio requirements. This would increase balance sheet capacity which for some could then be deployed into gilts, thus supporting gilt performance vs swaps and absorbing additional supply. The key is for some – it is possible this balance sheet could be diverted to other products and indeed the BoE would rather it was focused on lending to households. Another mention of repo market reform was made within the document, indicating that benefits may be smaller than anticipated if aligned with repo market changes. Nevertheless, it was welcomed as a move to simplify regulations and was seen as positive by the market.
Total interest rate liability hedging activity remained consistent at £36.2 billion, whilst inflation hedging rose slightly to £34.9 billion. Increased focus on hedge accuracy within LDI mandates whether preparing for buy-out or looking to run on resulted in trade activity, as well as some opportunities in relative value transactions. In recent years the UK’s bond market has been seen as good value particularly by insurance companies weighing them up versus expensive corporate bonds. This had resulted in some idiosyncratic behaviours particularly in index-linked gilts. This interest has turned aside from the UK to consider other bonds such as in the US or Europe.
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 30 June 2026
The funding ratio index published by the Pension Protection Fund showed little change in funding levels quarter-on-quarter (131.2% at end June vs 131.4% at end March). Strength in equity markets offset slightly lower yields balancing the impact on the funding ratio.
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. A negative balance indicates more responses predicting a fall.
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 30 June 2026
Last quarter our counterparties expected a fall in all three metrics which was borne out in interest rate and inflation, however the fall in inflation proved dominant as a result of a temporarily positive outlook on the Iran conflict and real yields rose. Looking forward once again our counterparties predict falls albeit with very low conviction for the inflation swap rate. Arguments for a fall in swap rates is focused on a much hoped for resolution of the Iran conflict and a pick-up in demand from LDI and insurance whilst supply in the longer maturities is kept to a minimum. Yet the fiscal situation and market expectations could impact this view; higher spending without appropriate taxation would lead to a higher term premium and thus higher yields – however this eventuality seems to be discounted by the market at present. The lack of conviction in inflation reflects the binary impact of the closure of the Strait of Hormuz. Oil and natural gas remain volatile and will likely become more so as inventories continue to be depleted. The severity of the drought in the UK and Europe whether through wildfires or its impact on crops could also contribute to a higher inflationary environment and risks becoming entrenched in sentiment. Lack of meaningful index-linked gilt supply may limit the scope for inflation rates to rise significantly.
If you would like to learn more about any of the topics discussed, please contact your client director.
