By Jonathan Crowther
This month the inflation print has hit the headlines again as the Retail Price Index (RPI) surprised marginally to the upside at 1.1%. The Consumer Price Index (CPI) level remained around zero with the August print coming in at 0.0%.
As a result, the RPI-CPI wedge has widened slightly over the month to 1.1%. While at the top of the recent range, it has remained relatively stable between 0.7% – 1.1% since late 2013.
Market versus forecasts
What does offer some pause for thought however, is the level at which the RPI-CPI wedge trades compared to fundamental expectations of this level. Although CPI swaps are traded infrequently, those CPI swaps that have been traded had a spread of 0.5% – 0.6% below the level of RPI swaps1. This compares to most long-term expectations of the wedge of 0.8% – 1.4% (early 2014, the Bank of England (BoE) forecast a central long run estimate of 1.3%2). We would argue that a wedge of approximately 0.5% – 0.6% is therefore attractive and actual prints are likely to be higher over the long term. This is due to:
– The long-term factor: The method used to aggregate prices for both indices is different, resulting in the “formula effect”. RPI uses a combination of arithmetic approaches, Carli and Dutot, whereas CPI uses mainly a geometric approach, Jevons. Between 2005 and 2013 the formula effect contributed 0.7% to the wedge. The BoE’s central long run estimate for the impact of the formula effect is 0.9%2.
– The short-term factor: At historic lows, base rates are likely to rise in the future rather than fall. As base rates impact mortgage costs which contribute to RPI and not CPI, this would increase the wedge during a rate rising economic cycle.
Potential strategic solutions
A level so far out of line, compared to long-term expectations, represents an opportunity for investors. Taking a long RPI swap and a short CPI swap position could offer a positive return to investors, should the wedge be greater than where the market level implies (0.5% – 0.6%).
– The trade could be held in isolation until maturity to profit if the actual RPI and CPI levels print higher than the market implied wedge going forward.
– Schemes could benefit if in the process of strategically unwinding some inflation hedging. This could occur for numerous reasons, such as updated cashflows reducing the inflation sensitivity of the liabilities or if there has been a pension increase exchange. It could be more cost effective to sell CPI and lock in the wedge at the current low market rate, rather than selling RPI.
Considerations and timing
One issue with this trade, and the reason behind the attractive levels of the RPI-CPI wedge, is that RPI is the frequently traded measure of inflation and CPI is not. CPI is therefore far less liquid, and the potential costs of implementing a CPI swap, and therefore this trade, would likely be significant.
Transaction costs would be higher than for standard RPI swaps, with spread levels likely to be around 5bps rather than the standard approximate 1bps for RPI swaps. Deals involving CPI are also more ad hoc, such a trade would therefore be more difficult to unwind.
However, liquidity issues should not cause concern for clients that are able to hold both swaps to maturity. In this event, an investor would receive the difference between the actual wedge and the initially traded level.
If liquidity for CPI swaps improves the market level for the wedge would increase as CPI swaps become cheaper, allowing investors to crystalise any future gains by closing out their positions. A potential driver of CPI liquidity improvement would be an increase in CPI supply, this could be in the form of CPI-linked debt issuance from the UK Government.
Conclusion
We believe that owing to liquidity issues stemming from a lack of supply, the market level of the RPI-CPI wedge appears too low compared to the expectations of what is likely to happen over the longer term. That the RPI-CPI wedge will be greater than 0.5% – 0.6% over the longer term seems reasonable, and trading this view may reward investors with a positive carry and the potential for an immediate gain if CPI index-linked gilts are issued and liquidity in this market increases.
Jonathan Crowther is head of UK LDI team at Axa IM
1 Source: Total Derivatives, July 2014 and panel of investment banks 2015
2 Bank of England February 2014 Quarterly Inflation Report
3Source: Lloyds Bank press release, 11 May 2015
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