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Repo rates are expressed relative to SONIA, and the chart below displays the average repo rates that we have achieved over the past four quarters for three, six, nine and 12-month repos, shown as a spread to average SONIA levels at the time. The volatility and market uncertainty that resulted from the mini-Budget also weighed upon funding markets, particularly for shorter dated trades as can be seen from the achieved spreads below. Note that during the fourth quarter of 2022 no repos were traded with a 12m tenor so the chart reflects the previous quarter’s value.
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Figure 2: Change in swap rates over the next quarter
The secondary impact of the mini-Budget crisis centred around collateral and the velocity of movement; rather than a lack of balance sheet for repo funding (a la March 2020). Yet, the difficulties around collateral substitutions and settlements did in many cases prompt a review by individual banks’ credit officers, resulting in a temporary reduction or hiatus in repo balance sheet provision in some cases. Once these reviews were completed balance sheet availability opened up again – some with the addition of haircuts to provide additional protection to the bank. Of course, the momentous lack of certainty in the future path of interest rates also impacted the typical repo spread to SONIA as trading a fixed rate forced the banks to take a conservative view on where yields could reach.
The funding ratio index published by the Pension Protection Fund showed a slight decrease in funding levels quarter-on-quarter (124.7% at end March vs 125.7% at end December). Higher yields benefitted the liability side of the equation, however the dramatic fall in equities weighed upon funding ratios. High hedging levels mean that schemes saw only a modest gain from the higher yields but still retain some exposure to equities.
Market Outlook
Source: Columbia Threadneedle Investments. As at 31 March 2025
Inflation hedging rose by 12% quarter on quarter, whilst interest rate hedging activity increased by 27% from the previous quarter.
All data and sources Columbia Threadneedle Management Limited, as at 30 June 2024 and Valid to: 30 September 2024
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President Trump’s ‘Liberation Day’ antics dominated the quarter as markets struggled to digest the volatile news-flow.
Whilst tariffs have come and gone, risen and fallen; the one aspect that most agree upon is that the uncertainty will weigh upon growth as companies pause investment and hiring decisions as they await clarity. A similar story may play out in the UK regarding the likely ongoing amendments to the tax environment.
The initial market response to the larger than anticipated tariffs were a sharp drop in equities and an increase in government yields (fall in prices). The lack of diversification between equities and fixed income was highly unusual in the US which has benefitted from hyper-exceptionalism as the world’s reserve currency and also the government bond safe haven of choice. Unfortunately, as is often the case, this effect was reflected in global markets, with the UK exhibiting a worrying correlation with the US. Much was made of the trade activity, questioning whether China and other highly tariffed countries were selling US Treasuries and dollars as a punishment; however the drivers largely came down to hedge funds unwinding significant leveraged positions and markets attempting to price in the potential negative impacts to growth and higher inflation. The bond vigilantes won the day and President Trump granted a much welcomed 90-day respite – to allow countries to negotiate trade deals ‘in good faith’. As tariffs were threatened and then reduced the markets began to exhibit tariff fatigue and the phrase TACO (Trump Always Chickens Out) helped equity markets shrug off the danger and reach new highs. Given the uncertainty about what the terminal levels of tariffs might be and in what industries, the US Federal Reserve have been reluctant to cut rates, prompting ire from President Trump and threats of sacking Fed Chair Jerome Powell unless he progresses the monetary easing cycle (by 3% no less!).
In the UK, the Labour Party reached the one-year anniversary of their landslide victory. However there have been few victories to celebrate. Initial attempts to rein in spending have resulted in U-turns (winter fuel payments) or embarrassing climbdowns such as the much watered-down Welfare Bill. It has become clear that despite the challenging fiscal environment there is little will in the Labour backbenches to make hard decisions. This poses a problem for Chancellor Rachel Reeves, already struggling with her unnecessarily stringent fiscal rules and the global trend for higher yields, thus increasing the cost of servicing the debt. Inflation has been creeping up, creating more complexity for the Bank of England as they consider the negative impacts on growth and how best to support the economy. Despite that they were able to cut the base rate by 0.25% in May, reaching 4.25%. The Bank of England and Debt Management Office displayed a welcome sensitivity to markets as they considered the impact of supply on the longer maturities which showed signs of stress, of course impacted by global markets but also more idiosyncratic domestic factors of demand versus the weight of supply.
Total interest rate liability hedging activity decreased to £30.4 billion, whilst inflation hedging rose to £27.1 billion. Volatility and the uncertainty in the market dampened demand for LDI hedging, although some were open to opportunities to lock in higher yields. The supply and demand picture for longer maturity UK government debt was an area of focus over the quarter and looking forwards. The Debt Management Office (DMO) took the unusual step of using the remit revision not simply to allocate the small increase in remit but to respond to higher yields and thus higher costs and skewed their issuance profile shorter, reducing the allocation to longs to 10% over the course of the fiscal year. This was well received by the market, yet global factors drove a continued rise in yields. Clearly, despite their action, there is still pressure on longer dated debt as LDI demand has diminished and bank treasuries and overseas investors are more focused on the shorter maturities. Insurance companies have been the surprise factor. In past quarters we have discussed the change in allocation towards government bonds and away from credit and swaps due to compressed credit spreads and bonds appearing quite attractive versus their mandated swap discounting. There was concern that if credit spreads were to widen that insurance companies could cycle out of government bonds, however it now appears that this demand may be stickier than previously thought and may indicate a persistent shift in allocations, particularly at the longer maturities.
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.
Figure 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 2025
The funding ratio index published by the Pension Protection Fund showed an increase in funding levels quarter-on-quarter (126.2% at end June vs 124.7% at end March). Higher real yields and the resurgence of US equities drove this gain. The recent introduction of the Pensions Schemes Bill has opened up new avenues for pension schemes as they weigh up run-on and surplus extraction versus buy-out opportunities.
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. The more negative the balance, the more responses predict a fall.
Figure 2: Change in swap rates over the next quarter
Source: Columbia Threadneedle Investments. As at 30 June 2025
Last quarter our counterparties expected a fall in real and nominal yields with no clear direction on inflation. They had posited that tariff uncertainty and negative economic impacts would encourage the Bank of England to cut rates aggressively and hoped that that the shorter skew in issuance would result in 30-year yields falling. Unfortunately, global drivers and fiscal concerns saw 30-year yields rise.
Looking forwards to the end of September our counterparties predict a fall in all three metrics, albeit with little certainty on real yields. A major driver of inflation is of course energy prices and there is hope that if geopolitical strife subsides this and reduces realised inflation it could lead to a normalisation in expensive long dated inflation yields. The arguments in favour of lower nominal yields are for supply to evolve, reducing the pressure on these tenors and for the Bank of England to continue cutting rates. Buyout activity is traditionally higher in the second half of the year and as such could weigh upon yields. However fiscal concerns and wider global market moves could stymie this prediction, particularly given the need to attract foreign investors to support the debt burden.
Of our counterparties 79% expect the Bank Rate to reach 3.75% by the end of the year, with cuts in August and November. For those who felt there was potential to do more, it was predicated on the potential for labour market weakness and inflation remaining under control. The fiscal situation and the likely changes in the Autumn Budget remain a key focus for UK investors. With the lack of progress on spending reductions, the consensus view is that Chancellor Reeves must raise taxes in order to comply with her fiscal rules. The market reaction to her rumoured defenestration has lowered expectations of a reshuffle, and it may also mean that there is a smaller chance of an adjustment to those rules, citing the adverse impact of tariffs on growth. Whilst there are small budgetary gains to be made from taxing gambling and alcohol further, these are rounding errors and therefore an election pledge not to raise taxes on working people may have to be broken. There has been much discussion of how the Bank of England will approach the continuation of its quantitative tightening programme. It is clear that they prefer repo market operations to support financial stability, however selling more long dated bonds may cause the market stress. Recently the BoE has maintained an £100bn envelope per year for quantitative tightening. This is comprised both of passive runoff i.e. maturities and active sales. In the most recent year there were substantial maturities, limiting the active sales to c. £20bn. Next year there are only £49bn of passive run off and our counterparties therefore believe that the total envelope is likely to be reduced with the average expectation at £75bn. In addition our counterparties believe that there is potential to skew the distribution of the active sales, focusing more on shorter dated bonds. However, that does mean storing up a long-dated problem for another day. Either way, a reduction in active sales permits balance sheet to be lowered whilst lessening the effect on long dated yields. Governor Bailey recently confirmed that this was an active discussion. Given that the UK Treasury bears the cost of losses on the portfolio, a reduction in active sales may also be well received by Chancellor Reeves!
If you would like to learn more about any of the topics discussed, please contact your Client Director.
