The Bank of England (the Bank) announced on 16th December 2021 that it was raising interest rates from 0.1% to 0.25%, putting markets slightly off balance as the general expectation was that any rate rises would be delayed, due to the potential impact of the Omicron COVID-19 variant.
Whilst there was an initial spike upwards in yields, the overall market reaction by the close of business on the day of the announcement was fairly muted. However, we suspect this may be the calm before the storm, noting that yields have already edged up over the Christmas period.
Markets had expected the Bank to act earlier in the autumn. With the fundamental economic situation today being rather less certain than it was then (due to Omicron etc.), markets were initially somewhat taken aback by the Bank’s decision to act. However, a small rise in nominal yields is in itself no big deal. We reckon the Bank wanted to recover its poise before the end of the year, since 2022 is likely to be a challenging year for policymakers.
Stepping back from the recent rate rise
The gilt market could be described as somewhat dysfunctional at the moment, grappling with the prospect of higher inflation, mixed signals from the Bank, the recent end of Bank purchases and a lack of issuance in the remainder of this fiscal year. However, there is an increased chance that bonds bought as part of Quantitative Easing (QE) that mature early this year may not be replaced, which will reduce the 
buying pressure within the market. Further, with new issuance in Q2 2022 and no QE program to mop it up, the chances of rising gilt yields and a steepening of the curve have increased materially.
Against this background it is worth considering the extremes reached by the gilt market recently. Specifically, for a short period in early December, we saw forward rates at longer terms fall below zero (see chart).
In addition to all this, gilt / swap spreads at the longer end of the curve narrowed during 2021, and market-implied inflation rates rose materially over last year, albeit they have fallen back from the heights reached in late October.
What does all this mean for pension schemes?
Whatever you think about predicting markets, the current economic fundamentals, or the policy situation, a few things are clear:
- The gilt curve is distorted due to the technical factors outlined above. If schemes have adopted proxy hedging that has benefited from this, now would be a good time to consider whether it is appropriate to introduce a better matched hedge.
- The gilt supply / demand dynamics are likely to change materially this year, particularly after Q1 2022. There is a heightened risk of interest rates rising, which should be factored into all liability hedging decisions. Further, for those schemes with leveraged LDI, make sure you have robust collateral waterfalls in place to meet any cash calls arising from a rise in yields. Be aware that any sale of growth assets to meet these cash calls could impact journey plans currently in place.
- With various moving parts, it is difficult to say what the recent dynamics will have done to hedging ratios vs. those being targeted. However, if these haven’t been reviewed recently, now would be a good time to do so.
- The balance between a scheme’s nominal and real interest rate exposures will change as inflation expectations change. With this in mind, if heightened market volatility continues, trustees should consider more frequent hedging updates to mitigate the increased liability mismatch risks that will arise.
- Although the recent rise in actual inflation may work itself out to some degree during 2022, we believe the risk of higher long-term inflation has materially increased. For more background, watch the video of our summer seminar “Tomorrow never knows” (click here).
- The above gives rise to questions on how clients should structure their portfolios to mitigate the downside risks arising from inflation. Watch this space, for the next in our new series of blogs.
Important notice: This article is for Professional investors only and was written as at 4 January 2022. The article is generic in nature and should not be regarded as providing specific advice or a recommendation of suitability. No action should be taken without seeking appropriate advice, taking account of how the market environment has changed since the date of this article. There can be no guarantee that the opinions expressed in this document will prove correct.