Views from the LDI desk – January 2024

Not another 2024 Outlook

Its customary at the start of the year to receive a deluge of outlook pieces, trying to predict events for the year ahead. The past few years have shown us this an incredibly difficult task.

So, in the interests of remaining humble, this is not a 2024 outlook in a classic sense of the word but simply a summary of some of the things we expect to be thinking and writing about over the next few months. These are based on the trends we expect to see as the year progresses, but one thing you can guarantee is that events that no one expected will transpire.

We also appreciate the continued feedback from our clients and broader readership - are there things on your mind that you would like us to further explore or write about? Reach out to your usual BlackRock representatives with any thoughts or ideas. We are always fascinated to hear what you are thinking.

Where are we starting 2024?

The end of 2023 saw a powerful rally in almost all markets, including fixed income, as central banks began to indicate the end of the sharp hiking cycle seen over 2022 and 2023. The December Federal Reserve (Fed) dot plots, which capture the forward-looking rate expectations of Fed members, showed 3 cuts in 2024. While this was fewer than the 5 cuts the market was pricing, it was enough to give bond buyers confidence of the pivot being on the horizon and to start buying.

In the UK, the November inflation print released on the 20 December showed a sharp slow down in inflation with CPI falling to 3.9%, below economist expectations of 4.3% and where the Bank of England (BoE) thought inflation would be printing at this point. Core inflation also declined, dropping to 5.1%, with goods inflation in particular driving the declines.

While inflation remains well above the 2% target and the labour market and wage growth expectations remain strong, momentum is gathering behind a downward path for inflation. This is leading to market pricing at the start of January expecting almost 1.5% of cuts to the UK base rate from the Bank of England (BoE) over 2024.

BoE pricing has followed the Fed in pricing almost six 0.25% cuts in 2024

These factors combined led to a rally of over 1% in longer dated gilt yields into year end, pushing 30yr real yields back below 1% temporarily. The start of the year has seen yields move a little higher again, possibly as market participants start to position for the heavy supply year ahead. Although we would caution that too much shouldn’t be read into thin markets either side of Christmas holidays and the next few weeks will be telling.

30yr nominal gilt yields

30yr real gilt yields

Despite the end of 2023 rally in gilt yields, gilt asset swap levels (the yield relative to swaps) has been weak. Global asset swap levels have struggled over the course of the year with bonds cheapening relative to swaps on the supply story as governments battle large deficits, but there has been a particular underperformance in gilts of late.

Yield pickup from Gilts and US treasuries vs. swaps – gilts have underperformed of late

We suspect this underperformance can be attributed to several drivers:

• Debt Management Office announced a Gilt remit reduction at the Autumn Statement but cut less from long dated issuance than many expected, instead cutting the issuance of short dated Treasury Bills by £10bn.
• LDI demand for hedge extensions and rebalancing purchases remains relatively muted as the effects of mortality, inflation caps and conservatism around collateral buffers continue to feed through.
• Large insurance transactions going through the market, for example Boots, with insurers likely switching gilts taken on into credit.
• Update in late December 2023 from the BoE on their programme of Quantitative Tightening gilt sales, which slightly rebalanced sales towards shorter dated bonds. While this might have been expected to support longer dated yields, the overall size of the adjustment is really quite modest (around £1.5m PV01 over Q1) and many might have been hoping for a more material adjustment.

As we go into 2024, while rate cuts may start to happen (even if we question the pace expected) the fundamental bond supply and demand picture is likely to remain challenging, keeping longer dated yields elevated. UK defined benefit schemes are likely to continue to find themselves with higher than anticipated funding levels and facing important choices about their future and purpose.

What will we be focussing on in the coming months?

End game is (mostly) upon us – many schemes are re-evaluating their plans on buy-out or self-sufficiency. But how do you manage the risks to buy-out if this is likely to take some time to execute due to data cleansing or market capacity challenges? What’s the right level of credit and how do most transitions with insurers happen when it comes to asset transition? If you are running on to build a surplus, what considerations are there in investing and hedging this? We will explore these questions in further detail.

Revisiting credit allocations – where are the best opportunities in credit? Is it time to revisit the buy and maintain approach to managing credit and consider other options? We’ll consider the arguments and integration into LDI portfolios.

UK election year and the path of gilt supply – the Government expects to hold an election in 2024 and the budget announced for 6 March 2024 will be a key opportunity for the government to set out its stall on potential tax cuts. With falling gilt yields and expectations of cuts to the base rate now priced in, further fiscal headroom may develop. This could further boost gilt supply in what was already expected to be a record year for issuance. The supply and demand dynamic for gilts will continue to be key and we might be left asking who will buy even more gilts?

Repo redux – While leverage is significantly lower than it was, most schemes still need some and gilt repo remains the preferred route. Repo markets have been quiet over the past couple of years, with relatively tight spreads to SONIA achievable and ample balance sheet availability. While we don’t imminently expect this to change, there are some new developments and innovations on the horizon in how we trade and manage repo that we will be diving into in further detail. This includes floating rate and evergreen repo structures that can better manage short-dated interest rate risks and roll risks, as well as further updates on the roll out and test trades for credit collateralised gilt repo as we establish this nascent market.

UK Clearing exemption – what are the implications of the UK Government following the EU and allowing the pension exemption to expire in June 2025? Following a recent government consultation on the topic, we will dive back into this area to consider the impacts on wider market dynamics and individual schemes.

As ever with financial markets, things are subject to change at short notice and there is a high level of continued macro, geopolitical and local political uncertainty as we enter 2024. We will continue to provide timely updates on any key market events and emerging trends impacting UK pension schemes and look forward to partnering with our clients and others in the market over 2024.