A finger in the dam
The supply side of the equation has an equally important role to play in determining the force the flood of money can excerpt on the market. In a perfect world, supply would simply be increased as trigger points were reached to absorb the extra demand. However, with the Bank of England (BoE) sitting on around a third of the total gilt supply, an orderly matching of demand and supply looks unlikely. Furthermore, the BoE’s policy is governed by broader economic factors, including the unemployment rate, and is unlikely to change quickly. The Monetary Policy Committee does make considerable effort to understand the dynamics of the bond market by speaking regularly with market participants including asset managers and those within the pension committee. Despite this, the concerns of institutions wanting to de-risk may not be enough to change policy and spark a sale of the £400bn stock of gilts the BoE is holding on its books. Policy is generally set off the shorter end of the curve while trigger points for de-risking will be further along the curve. “If rates go up at the long-end, it may not affect policy decisions, which tend to be more focussed on the short-end such as the 10-year gilt yield,” explains Marius Penderis, head of UK LDI solution structuring at F&C Investments. Furthermore, yields at the longer-dated end of the curve will likely move faster than the BoE is willing to adapt policy. It is unlikely the BoE will begin selling its stock of bonds before the 4% trigger point on long-dated bonds is reached, for example. This is not only because of its need to consider a wider range of economic indicators (such as unemployment hitting 7%), but also because of its strategy of issuing forward guidance to influence markets. As Amey says: “If the Bank of England starts selling its stock of bonds, it will likely announce a programme of sales over a sustained time horizon. It won’t sell for years yet. It will likely raise rates first, to around 1.5% or 2% and then assess the economic health and only then will it contemplate selling. The 4% mark on 30-year gilt yields will likely be breached before then.” The chance of an increase in supply of gilts to meet demand around key trigger points is therefore unlikely. Ultimately, low long-term interest rates suit a central bank in a country trying to inflate its massive debt away.
Regulating the flow
With little chance of a balance in demand/ supply dynamics, yields will likely react more sharply as triggers are hit and bounce for more sustained periods than they otherwise would. There has been some talk among market participants of beginning to trade just shy of trigger points, for example as yields reach 3.99%. And, with some degree of predictability in where those trigger points lie, some front running should be expected, which will further disadvantage institutions. “Investors could have a strategy that guesses what the trigger points are and implements a counter-intuitive strategy around those, for example, buying equities and selling bonds 24 hours after the 4% yield mark has been reached,” explains Mattingly. “Trading around those triggers implies knowledge of what those triggers are though and the data is difficult to access so it is not as clear cut.” The information does exist, but it is a question of whether it is accessible and collatable. The big consultants and key LDI providers will have data on their individual clients and will be able to get a picture of where the key pressure points will be as well as the scale of money likely to move. “Consultants should be looking at this as it could cost their clients a lot of money unless they are the first few movers,” Mattingly states. “The transactions cannot all happen at the same time so some people will lose out. The last one will, by definition, be detrimented, potentially materially.” De-risking has already begun to impact the yield path, which is already clear in the longdated end of the market, especially for inflation- linked bonds. As yields continue their path to normalisation in the coming years, schemes need to push their consultants to fully understand the demand dynamics as key trigger points are breached. Some schemes will need to ensure they have sufficient tail-risk protection in place in the eventuality that de-risking could take considerably longer than expected. All investors will need to consider the impact on transaction costs of de-risking at key trigger points, especially given the slim likelihood of a simultaneous increase in supply to minimise the disruption caused by a flood of money hitting the bond market at the same time. Much remains uncertain, but one thing is clear, as Penderis concludes: “As rates increase, so demand will increase.”
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