A snapshot of the UK inflation market covering the three months to 31 August 2022
Supply outlook
An emergency budget is widely expected to be announced on 21 September, now that a new Prime Minister is in place. This budget will centre around an emergency fiscal package to help consumers with the cost-of-living crisis and, more specifically, the upward revision of the OFGEM price cap that was announced on 26 August (effective October). The review of the price cap has also moved from a 6-monthly to a 3-monthly cycle; so based on the current gas forward curve, the price cap will rise again in January, above the previously predicted peak in October.
With the emergency budget likely to be a significant fiscal event and the most recent fiscal forecasts stale from March, we are expecting the OBR to issue new projections and for a new gilt remit to be announced earlier than the usual October / November timeframe.
There is high uncertainty around gilt issuance projections for the remainder of the fiscal year: on one hand, the CGNCR1, which feeds directly into gilt issuance, has been realising lower than the OBR’s projections – as higher inflation tends to boost tax receipts and spending has been tracking lower than predicted. On the other hand, discretionary fiscal measures are likely to be substantial and take effect sooner than the next tax year. Nonetheless, even with large revisions to the gilt remit, our view is that index-linked gilt issuance is unlikely to change meaningfully, as adjustments tend to be made to short or medium buckets to limit market impact.
Figure 1: Inflation-linked issuance2, August 2022
Source: Columbia Threadneedle Investments, DMO
Figure 2: Distribution of inflation exposure issued, by maturity buckets, August 2022
Source: Columbia Threadneedle Investments, DMO
1Central Government Net Cash Requirement
2Columbia Threadneedle Investments assumptions for fiscal year 2022/23 as follows –
– Cash raised based on assumption that auctions have average size ranging between £700 million to £1,250 million; and planned £8.5 billion to be raised over two syndications.
– Auctions beyond August 2022 have also been extrapolated based on the auctions already confirmed for April to December.
– For the two syndications, a 2073 was selected for April but the other scheduled for November is still unconfirmed.
Market liquidity
Volatility is here to stay, particularly for shorter-dated inflation instruments. With heightened political risks, gas pipeline supply disruptions and the OFGEM price cap rise in October – there are no clear signs of market uncertainty abating in the near future. Consequently, market participants, such as banks, whose risk limits are Value at Risk (VaR)-constrained have a lower risk appetite, making them unable/unwilling to warehouse risk when intermediating trades. Consequently, liquidity is thin, translating into wider bid/offers.
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 £50k risk, median = 100%, August 2022
Source: Columbia Threadneedle Investments
At the tenor points of 10, 30 and 50-year respectively, mean bid-offer spreads3 were 1.9bps, 1.6bps and 2.0bps for RPI swaps; and 1.8bps, 1.6bps and 1.9bps for inflation-linked gilts.
In future editions of our Inflation Quarterly Monitor, we will update the liquidity tracker, with the initial median normalised at 100%. The movements in the median will indicate outright changes in transaction costs, while the change in the upper and lower quartiles will indicate the dispersion of these costs.
3These are generic market indicators and are not representative of the levels Columbia Threadneedle Investments might trade at.
Gilt versus swap inflation
Over the three months to August month-end, gilt inflation outperformed relative to swap inflation up until the end of June, then cheapened beyond that point. This relative cheapening has been cited as the result of buyout flows, which are forecast to increase further into the end of the year and into next year, as pricing looks attractive and strong solvency ratios boost demand. Additionally, the potential reform of Solvency II to widen the scope of assets eligible for matching adjustment and to reduce capital requirements would be beneficial to buyout pricing, further supporting the cheapening of gilt inflation relative to swap inflation.
Figure 4: Relative z-spread for generic inflation-linked bonds versus comparator SONIA z-spread (3 months to 31 August 2022 highlighted), where higher (lower) level indicates swap inflation outperforming (underperforming) gilt inflation
Source: Barclays Live
CPI market update
Not only does the forward wedge not indicate alignment of RPI to CPIH from 2030, but it has also widened since the announcement in November 2020, even as we inch closer to the alignment date. This could be due to flows in the opaque wedge market and the more recent divergence in CPI and CPIH4.
Over the quarter, a mix of 10 to 20-year CPI and RPI corporate supply, accompanied by RPI selling and interest rate swap paying, came to market. Consequently, some banks re-priced the wedge at shorter tenors. These flows might be linked in part to the results of the fourth round of CfD5 allocations that were announced at the start of July. However, it is worth bearing in mind that whilst some winning bidders may opt to pay away their CPI-linked income streams via the CPI swap market, there are others who may prefer not to hedge at all. This is dependent on the type of corporate strategy employed by auction participants or their parent company.
Figure 5: Indicative spread between RPI and CPI swaps expressed as a strip of forwards6, at 25 November 2020 (RPI reform announcement), 31 May and 31 August 2022
Source: Columbia Threadneedle Investments, Morgan Stanley
