Views from the LDI Desk – February 2025

A frenetic start to 2025

5 minute read

2025 has gotten off to a flying start, with volatility in global bond markets, questions on the direction of the UK economy and the start of a potential new set of trade wars. We’ve also had several key updates from UK institutions on both big picture and more technical matters that are important to UK pensions and their LDI strategies. We will revisit the wider questions on UK DB pensions changes, surplus extraction and run-on at another time - in this update, we summarise some of the other key activity we’ve seen in the past month. 

Clearing exemption

The UK previously diverged from the EU and extended the clearing exemption for pension funds – the latest extension was due to expire in June 2025. In January 2025 the UK Government produced their formal response to the call for evidence on the pension fund clearing exemption and determined that the exemption will be maintained for the foreseeable future.

Key points

• Many schemes hedge using predominantly gilts, funded through repo.
• There remains a broad preference in the market for bilateral over cleared swaps given additional margining requirements in clearing (Initial Margin, cash variation margin).

His Majesty’s Treasury (HMT) also highlighted a few concerns in their response;

• Mandatory clearing may force Schemes and managers to hold larger cash holdings, reducing their ability to invest in growth assets
• Removing the exemption could make stress events worse by increasing liquidity pressures, which in turn could increase likelihood of financial instability (i.e. demand for cash)
• Differences in market structure making the UK less competitive

Key takeaways

• Exemption will no longer be expiring on 18^th June 2025 and the HMT are removing any further time limit on the exemption, with a view to keep this policy under review in coordination with regulatory authorities.

We thoroughly welcome this approach and flexibility it retains for our clients. BlackRock have engaged extensively on this issue over the years, including through our response to the consultation in early 2024. For our clients, we believe that adopting a situational and pragmatic approach with the ability to utilise cleared and bi-lateral derivatives is optimal. Utilizing bilateral derivatives for enabling collateral efficiency and cleared derivatives where portfolios have higher levels of turnover and may benefit greatly from higher liquidity and lower transaction costs.

Contingent NBFI repo facility (CNRF)

January also saw the formal launch of the application process for the Bank of England’s (BoE) CNRF facility. As we previously wrote in September 2024, this facility is designed to offer financing directly to pension schemes, insurers and LDI funds to mitigate wider market risks of an inability to access repo financing through commercial banks in the repo market.

The Bank of England published a market notice on the CNRF, now accepting applications from eligible participants to sign-up for the program. However, the application of a £2bn hurdle rate in gilt holdings will rule many schemes out of using the facility.

Key takeaways

• Eligible for Insurance companies, pensions funds, and LDI investment funds with greater than £2bn in Gilts.
• Pricing: This will be specified at the point of activation using a spread to the Bank Rate and will be calibrated such that the facility is unattractive when compared to pricing in normal market conditions, but attractive during times of stress when the facility is active.
• Access fee of £8,000 annually.
• Structured as a collateralised loan, in line with other facilities offered by the BoE.

We continue to work closely with the BoE on the operational practicalities of using the facility and will be happy to work with eligible Schemes to commence set up of their portfolios for the CNRF where they wish to do so.

The spectre of stagflation

We saw a mixed set of data releases in the UK that have raised questions for the Bank of England; January UK PMIs painted a mixed picture for the UK, with the spectre of stagflation (i.e. a combination of high inflation and stagnant growth) growing. In addition, the UK labour market presented a picture of weaking labour demand combined with strong wages.

Employment growth continued to decline sharply following significant drops at the end of 2024, while unemployment ticked higher from 4.3% to 4.4%. Many firms attributed the upcoming hike in employer’s National Insurance to cutbacks in recruitment plans, while others pointed to a post-Budget slump in business confidence. While Inflation fell modestly in December, coming in below many expectations, this was likely driven in part by volatile categories such as airfares and hotel prices which are highly sensitive to collection timing and methodologies month to month. Meanwhile private sector wage growth excluding bonuses accelerated from 5.5% to 6.0% YoY, exceeding many forecasts.

A stronger manufacturing sector drove a modest increase in the growth outlook, but the overall level of surveys such as the Purchasing Manager Index (PMI) pointed to near stagnant growth.

Services Inflation remains sticky driven by continued strong wage growth

The current economic picture continues to create a real conundrum for the Bank of England (BoE). While on one hand a stagnant economy and weak job market would call for policy easing to stimulate growth, re-accelerating wage growth and still sticky core services inflation may limit what the BoE can deliver. Will the Bank be able to deliver the approx. 3 rate cuts currently priced in by the market this year at time of writing in early February?

Yield volatility is back with a vengeance

The first half of January was characterised by a selloff in UK and global governments bonds, driving yields significantly higher and increasing borrowing costs for governments. 10 and 30-year Gilt yields climbed up to levels not seen in decades, peaking on 15 January but subsequently normalising. While factors driving volatility were both global and domestic, fiscal policy was at the centre of attention in the UK. Inflation and debt concerns were paired with growing scepticism among investors about the UK Government’s ability to deliver on the ambitious growth targets set out by Chancellor Reeves in her Autumn Budget.

In her Autumn Budget, Reeves allowed for a relatively small £10bn headroom against fiscal rules. The table below shows how even modest changes in interest rates or inflation could easily wipe this headroom out, leaving very little room to manoeuvre. Since the Budget, we have already seen an uptick in Gilt yields, while the Office of National Statistics (ONS) has revised down its latest estimate of GDP growth. The Office for Budget Responsibility (OBR) is due to publish an Economic and Fiscal Forecast in March, which risks highlighting further borrowing needs, spending cuts, or tax changes.

Yields have now come down from their January highs, but, with increasing rhetoric around tariffs and trade wars yield volatility is likely to keep us company this year.

Fiscal headroom in the Autumn Budget could easily be wiped out by modest market moves

So what does this mean for Schemes?

• January has been eventful with lots of aspects at play that will likely have an impact on LDI portfolios during 2025. There are a few aspects worth looking out for;
  • OBR update on the medium-term forecast (March), and any potential changes in the fiscal plans of the Labour government.
  • BoE rhetoric around data from the next Monetary Policy Report and potential changes to the approach to Quantitative Tightening and equilibrium level of reserves later this year.
  • Continued rhetoric around additional tariffs and trade wars from President Trump.
• We look forward to continuing to follow each of these closely along with re-assessing portfolios and sharing our viewpoints during the year.

The opinions expressed are as of February 2025 and are subject to change at any time due to changes in market or economic conditions. The above descriptions are meant to be illustrative. There is no guarantee that any forecasts made will come to pass.

Risks

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