A snapshot of the UK inflation market covering the three months to 30 November 2022
Supply outlook
The three months to November month-end have been a period of astonishing moves, as gilts were taken on a wild ride after the September mini budget and accompanying remit revision triggered a skyrocketing of yields. This eventually forced the Bank of England to intervene via emergency gilt buyback operations.
Markets have since stabilised as political and fiscal risks have abated somewhat, albeit sentiment remains fragile. November’s revised Debt Management Office (DMO) financing remit delivered a larger than expected reduction of £24.4bn of gilt issuance, but we note that this is relative to the overinflated September remit revision. Overall, the latest figures still represent a significant increase from April.
The latest supply reduction has been driven by several factors. Firstly, government cash receipts have continued to run ahead of Office for Budget Responsibility (OBR) projections for the year, as inflation remains persistently high. Secondly, there has been a shift away from front-loaded tax cuts; meaning the cost of nearer-term fiscal measures will be lower than initially expected. Finally, the amount of support for, as well as the duration of the Energy Price Guarantee have both been reduced.
The impact of the reduction of index-linked gilt (linker) issuance was perhaps more of a surprise. Headline linker allocation was
trimmed from £21.2bn to £17bn, and hence the final significant supply event of the year – the UKTI 2073 syndication – was effectively cut by a third.
Although fiscal year 2022/23 gilt issuance came in below expectations, 2023/24 will be a lot larger than expected, with the OBR’s revised CGNCR forecast for 2023/24 having risen above previous projections (March remit CGNCR £74.4bn and gross financing requirement £191.3bn versus November remit CGNCR £188.1bn and gross financing requirement £305.1bn). Accounting for the Bank of England’s planned gilt sales of holdings accumulated during Quantitative Easing on top of this, we expect net gilt issuance to reach all-time highs next fiscal year.
Figure 1: Inflation-linked issuance2, November 2022
Source: Columbia Threadneedle Investments, DMO
Figure 2: Distribution of inflation exposure issued, by maturity buckets, November 2022
Source: Columbia Threadneedle Investments, DMO
1Central Government Net Cash Requirement – this figure feeds directly into gilt issuance
2Columbia Threadneedle assumptions for fiscal year 2022/23 are as follows –
– Cash raised based on assumption that auctions have reduced average size, ranging between £550 million to £900 million for events post November’s remit revision
– Auctions beyond December 2022 have also been extrapolated based on the auctions already confirmed for April to November
Market liquidity
Political and fiscal stresses that featured heavily at the end of September and throughout October exacerbated the already dire market liquidity, translating into wider bid-offer spreads. Although market conditions have since improved, volatility remains high.
At the tenor points of 10, 30 and 50-year respectively, mean bid-offer spreads3 were 2.1bps, 1.8bps and 2.4bps for RPI swaps; and 1.9bps, 1.8bps and 2.0bps for inflation-linked gilts. Medians are based at 100% off bid-offer spreads in August 2022. 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.
Between August 2022 and November 2022, transactions costs rose for RPI swaps across all tenors; whereas for linkers, costs only increased for the 30-year tenor, which also saw a larger range of costs.
Figure 3: Liquidity tracker4 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 £50k risk
Source: Columbia Threadneedle Investments
3These are generic market indicators and are not representative of the levels Columbia Threadneedle might trade at.
4Medians are indicated by a horizontal line, which is based at 100% in Aug-22 and are labelled as a percentage figure in Nov-22. Minimum and Maximum are indicated by whiskers, with dots marking any extreme data points. Upper and lower quartiles are indicated by the top and bottom boundaries of the boxes.
Gilt versus swap inflation
During the LDI-driven market volatility at the end of September and over October, gilt inflation underperformed swap inflation at shorter maturities but outperformed at longer maturities. This was primarily driven by the demand for ultra-linkers, at the expense of 20 and 30-year inflation-linked gilts, to achieve greater cash efficiency. The scale of the movements is shown in Figure 4.
Following the crisis, ultra-linkers unwound most of these gains versus RPI swaps. The 30s50s real yield curve steepened and was accelerated by UKTI 2073 being announced as the syndicated bond. However, after November’s supply reduction announcement, market participants were spurred on to buy ultra-linkers again ahead of the syndication in light of its reduced size, flattening the real yield curve. This outperformance was short-lived and following the syndication, ultra-linkers have continued to trade poorly.
On 29 November, the Bank of England commenced the sale of inflationlinked gilts it purchased during its emergency operations. This may present investors with opportunities to purchase at attractive real yields but will weigh on gilt inflation. Separately, the Government’s response to the potential reform of Solvency II was published in mid-November and appears bullish for the annuity buyout market, which tends to be gilt negative relative to swaps. These factors will likely drive the cheapening of gilt relative to swap inflation; although one would also need to consider outright duration moves and corporate supply as these are significant drivers of inflation.
Figure 4: Relative z-spread for generic inflation-linked gilts versus comparator SONIA z-spread (3 months to 30 November 2022 highlighted), where higher (lower) level indicates swap inflation outperforming (underperforming) gilt inflation
Source: Barclays Live
CPI market update
The beginning of September saw the High Court dismiss the judicial review for RPI reform set for 2030 – which was the widely expected result. It was therefore unsurprising that quoted prices for the RPI-CPI wedge did not immediately adjust following the announcement, particularly as CPI swaps do not trade frequently.
Over the three months to end November, there were no publicly announced corporate deals but there were some prices quoted in the interdealer market at maturities of 10y and shorter. Consequently, some banks re-priced the wedge at shorter tenors.
At the shortest part of the curve, mortgage payment rises versus house price declines have been working in different directions to impact the spot wedge. Mortgage costs are expected to rise further from here as current deals mature and people are forced to re-mortgage at higher rates, which will continue to widen the wedge; but this will take some time to feed through. Higher mortgage costs should then act to slow house price inflation, particularly as we head into a recession. But similarly, the decline in house prices feeds through to RPI with a lag and is unlikely to compress the wedge immediately.
Depending on which of these factors prevails, will dictate how the wedge evolves from here.
Figure 5: Indicative spread between RPI and CPI swaps expressed as a strip of forwards5, at 25 November 2020 (RPI reform announcement), 31 August and 30 November 2022
Source: Columbia Threadneedle Investments, Morgan Stanley
5The chart deconstructs the RPI-CPI spot wedge into a series of implied forwards, with tenors defined by the availability of data points. The first data point is the 2-year spot wedge (2022-2024), second data point is the 3-year wedge starting in 2 years (2024-2027), etc, finally ending with the ninth data point plotting the 5-year wedge starting in 25 years (2047-2052).
Key risks
The value of investments and any 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.
