Bond Traders Brace for U.K.’s Plan for a Flawed Inflation Gauge

The U.K.’s half a trillion pound inflation-linked debt market is set to be swayed by a technicality: how price rises are measured.

On Wednesday, the U.K. will release a long-awaited report on replacing the maligned Retail Price Index with the more preferred CPIH as the main inflation gauge. A switch to the new benchmark, which has shown consistently slower price increases since 2010, threatens to erode future returns on the securities.

The expected shift may be scheduled to take effect in 2030, according to Bloomberg Intelligence, but the risk is it could come sooner. That’s because a switch to CPIH-based inflation rates would help cut bond payouts for the government, which is borrowing record amounts to fund pandemic recovery efforts.

Bond Traders Brace for U.K.’s Plan for a Flawed Inflation Gauge

“Given the damage done to public finances over recent months, there is a stronger case to make the change as soon as possible,” said John Wraith, head of U.K. and European rates strategy at UBS Group AG. “There might be legal challenges from investors who bought linkers and believe they might be entitled to compensation, so it might be a while till any proposed change is definitively confirmed.”

Sterling-denominated five-year, five-year inflation swaps, a gauge of investor expectations for price rises over the next decade, dropped sharply this month to 3.43%, the lowest level since April. Britain’s inflation markets have long been distorted by strong demand from the country’s pension funds, which buy up the debt in an effort to meet future liabilities.

The Fallout

“The penny may have started to drop in the market,” said Adam Dent, U.K. rates strategist at Banco Santander SA. “Once the decision has been made, we expect demand for long-dated linkers and RPI swaps to surge after being very subdued for over a year.”

What Bloomberg Intelligence says

“Markets have been adjusting to the prospect of RPI reform but there is more room to go. The long-end of the curve is particularly exposed to a further fall. Timing is key, and an earlier start date would hit the market even more given it would be a surprise.”

-- Tanvir Sandhu, chief global derivatives strategist

Reform of the RPI measure will have far-reaching consequences from student loan repayments to rail fares. While the index is no longer a so-called national statistic, fixing it requires Sunak’s approval as bondholders face the prospect of lower returns.

Also on Wednesday, the U.K. debt management office is poised to provide details of its borrowing needs for the rest of the financial year, and Chancellor of the Exchequer Rishi Sunak is set to conclude the government’s spending review.

Next Week:

  • Auctions from Italy, Belgium and Netherlands are expected to total 14 billion euros ($16.6 billion), according to Commerzbank AG
    • France and Italy pay 36 billion euros in bond redemptions, alongside coupon payments of just under 2 billion euros next week
    • The U.K. will hold two gilt auctions next week, selling a combined 4 billion pounds of debt and buying back 4.4 billion pounds of securities across three operations.
  • Data releases include preliminary manufacturing and services PMI for November for the euro area, Germany and the U.K. as well as France, all on Monday
    • Germany’s Ifo survey for November and final 3Q growth numbers are due Tuesday
    • There is little on the U.K. data schedule aside from the PMI numbers
  • The coming week will offer plenty of opportunities for ECB policy makers to flag expectations for next month’s monetary policy meeting
    • ECB’s Isabel Schnabel, who is responsible for the bond-buying program, speaks at a money market conference Monday and again on Tuesday at a Bank of Finland webinar alongside fellow policy maker Olli Rehn
    • President Christine Lagarde and chief economist Philip Lane also speak on Tuesday; Robert Holzmann presents Austria’s financial stability report on Wednesday
    • Lane and Schnabel speak again on Thursday when the ECB publishes the minutes of its October policy meeting
  • BOE governor Andrew Bailey appears alongside chief economist Andy Haldane, Silvana Tenreyro and Michael Saunders at a Treasury select committee hearing on Wednesday
  • Moody’s Investors Service reviews Belgium and Fitch Ratings reviews Ireland on Friday

©2020 Bloomberg L.P.

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