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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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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 new Bank of England levy, implemented on 1st March 2024 commences its reference period in Q4. It will sample the liability data from each of the month ends in October, November and December in order to determine individual bank contributions. Thus, counterparties will be incentivised to reduce balance sheet availability over month ends, potentially worsening availability and cost of funding, especially when taken in conjunction with year-end window dressing impacts.
All data and sources Columbia Threadneedle Management Limited, as at 30 June 2024 and Valid to: 30 September 2024
Regions
The summer lull never really materialised this year as geopolitical risk considerations, and a significant election schedule remained at the fore, resulting in changeable investor sentiment and hence relative value opportunities
Inflation hedging rose by 12% quarter on quarter, whilst interest rate hedging activity increased by 27% from the previous quarter.
Despite the preponderance of major sporting events such as the UEFA European Football Championship and the Olympics over the summer, there was persistent activity in financial markets, as risk events demanded closer attention. Following on from their first foray into the rate cutting cycle, the ECB cut again in September by 0.25%. This time the trend took off, with the US Federal Reserve jumping in feet first with an unexpected 0.50% cut in September, whilst the UK had commenced their cycle with a 0.25% cut in August. With political change on the horizon in the US, the UK and the EU, central bank independence and agency to act is of the utmost importance. Whilst the cutting cycle is anticipated to continue at differing speeds for the various economic zones, the one known unknown is that the neutral rate where each economy is in harmony between growth and inflation is likely to be higher than in recent years. This makes it tricky for central banks to judge, particularly with lagged data and external economic influences and shocks. The UK is predicted to reduce rates on a quarterly basis over the coming year, a slower pace than others, given the higher inflationary pressures particularly from wages.
Total interest rate liability hedging activity increased to £41.8 billion, whilst inflation hedging also rose to £37.5 billion. Outright hedging activity was muted over the quarter, with interest thereby focused on relative value opportunities. This was centred on the relative cheapness of UK government debt versus other countries, corporate bonds and swaps. This interest has served to put a lid on the scope for gilts to cheapen significantly further relative to other assets. However, it has also democratised the holders of UK gilts, meaning a less clear reaction function if corporate bonds or the other comparators begin to look more attractive compared to gilts.
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 September 2024
The funding ratio index published by the Pension Protection Fund showed a slight fall in funding levels quarter-on-quarter (148.4% at end September vs 149.4% at end June) as yields fell resulting in liabilities increasing faster than assets where schemes are not fully hedged. This is despite equities, and US equities in particular, maintaining their seemingly unstoppable rally. The risk-off moment at the start of August was driven by concerns of contagion of violence in the Middle East but even then the S&P 500 rapidly bounced to hit new heights at the end of September. In large part, this is a result of market sentiment around President-elect Trump, who has campaigned on a platform of lower taxes and tariff protection for US companies.
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 September 2024
Last quarter our counterparties expected all three metrics to fall, but with little confidence in inflation. It was one of the rare quarters where their predictions were borne out! Their views were based on inflationary pressures reducing, giving scope to the Bank of England to set out upon the monetary loosening cycle and cut rates.
Until end 2024, our counterparties are confident in a fall in nominal and real yields and are more balanced on the outcome for inflation rates. Partly this is predicated on the typical LDI rush into year-end, which is supportive for yields, particularly in a time of lower than usual supply, and supply that is shorter in tenor than a comparable month, meaning that the longer tenors can be subject to downward yield (upward price) pressure. External factors are also supportive; such as the global monetary loosening cycle underway and the scope for further geopolitical ructions resulting in a flight to quality. It is also unlikely that significant volumes of corporate debt could be issued by year end, prompting a reconsideration of asset holdings for insurance and buy-out providers who have tilted their asset allocation more heavily towards gilts than might be the norm. On the other hand, markets could react to the possible future inflationary pressures from a high spending UK Budget and from a Trumpian drive for stimulus-led growth as well as the impact of greater issuance on the supply side, pushing yields up. Oil is a perennial culprit driving inflation in both a positive and negative sense, here the impact of a worsening outlook in the Middle East vs increased volumes from OPEC can create volatility but there is no clear direction at present. Year end balance sheet pressures could also impede access to funding to support new hedging programmes, thereby dampening LDI demand where counterparty access is restricted.
If you would like to learn more about any of the topics discussed, please contact your relationship manager.
