Market Economics | Interest Rate Strategy - BNP PARIBAS ...

The legislative changes to CPI indexation from
RPI could potentially impact 80% of defined
benefit pension fund members but is likely to be
much lower due to explicit RPI indexation in trust
deeds (40%?). The market impact of the news has
been very limited with 30y cash breakevens now
close to/above levels seen on 7 th July. We expect to
see breakeven weakness in the summer as the
implications of the legislative change to CPI are
calculated and supply continues. Nevertheless, there
is no liquid UK inflation hedging alternative to RPI
currently – RPI/CPI basis quoted at -5/-50bp (-30bp
mid) following the announcement. Furthermore,
given the size of the remaining ALM gap with respect
to inflation, we do not expect LDI demand for RPIlinked
assets to fall dramatically. Rather, the nature
of future UK inflation hedging demand will likely
evolve over time and become index specific
assuming the creation of a CPI-linked market.
Sell 30y BE, but i-40s Supply will be the Real Test
Beyond structural uncertainties, mid-summer months
typically exhibit limited LDI demand, particularly
August with (long) 30y BE total returns negative for
each of the past five years – Table 4. That said, 2010
is not a typical year given the abnormally poor Q2
performance of breakevens. Summer discounting
should limit the potential for further upside surprises
to UK inflation data, although June RPI surprised to
the upside yet again.
Ongoing uncertainty may limit appetite for RPI-linked
assets while the UK DMO still has to issue £26bn of
RPI linkers this fiscal year. With long-end breakevens
returned to their levels pre-announcement, we see a
material risk of a long-end breakeven correction
ahead. We expect a break below their 3.30-3.80%
‘normal’ range on 30y cash (Chart 6), if not targeting
3% (range is typically 20bp higher in swap). We enter
a new trade: Sell UKTi-40 breakeven at 3.40%
targeting 3.10% with a stop at 3.46%. Carry
of-0.6/-2.2/-3.2bp at 1/2/3m. The syndicated UKTi-40
issue in the second half of July will be the main test.
This said with GBP 34bn every year, the UK DMO
can build up a CPI-linked programme, in addition to
its RPI lines. RPI-linked assets remain the only
available liquid solution and the correlation between
RPI and CPI, whilst unstable, is 70% since 1990.
Finally, real yields are historically low but the same is
true for nominal yields and (at least) cash inflation
breakevens compare relatively well with past history
on RPI and long-term inflation expectations from our
economists (both around 3% y/y). At 2.60-70%, 10y
breakevens look even cheaper after the concession
into the decent £1.2bn UKTi-22 tap and we like
10/30y BE flatteners into 30y supply – Chart 7.
Real/nominal ASW discounts have proved volatile
and the very flat/inverted discount surface suggest
most value up to 20y maturities (Chart 8).
3.46
3.44
3.42
3.40
3.38
3.36
3.34
5: 30y UKTi RY & BE around Announcement
3.32
01-
Jul
02-
Jul
30y UKTi BE
30y UKTi RY
03-
Jul
04-
Jul
05-
Jul
06-
Jul
Steve Webb CPI
Announcement
07-
Jul
08-
Jul
09-
Jul
10-
Jul
DWP provides
more details
Table 4: 30y BE Total Return (Dur-adj) by Qtr
11-
Jul
12-
Jul
13-
Jul
14-
Jul
15-
Jul
0.84
0.82
0.8
0.78
0.76
0.74
0.72
0.7
0.68
0.66
0.64
16-
Jul
UKTI35 BE Tot Ret
Dur Adj
Apr May Jun Jul Aug Sep Oct Nov Dec
2003 0.3% -1.4% 2.4% 1.7% -1.0% 0.0% 2.0% -0.3% 1.4%
2004 2.7% 1.1% -1.3% -1.5% -1.1% -0.8% -1.5% -1.1% 1.7%
2005 -3.2% -2.9% -0.3% 1.1% -1.0% 2.1% 0.6% -2.0% -0.9%
2006 2.1% -1.6% 2.5% 0.3% -1.9% -0.7% -0.7% 0.6% 1.9%
2007 1.1% 1.4% 4.5% -3.2% -1.0% 2.2% -2.1% -0.1% -0.5%
2008 3.3% 3.7% 6.3% -6.1% -1.6% -4.4% -5.7% -12.0% -5.6%
2009 4.2% 10.0% -3.8% 1.2% -9.5% -1.5% 5.2% -1.2% 8.3%
2010 -3.6% -5.8% -3.8%
5y Avg (ex. 2010) 1.5% 2.1% 1.8% -1.3% -3.0% -0.5% -0.6% -2.9% 0.6%
4.40
4.00
3.60
3.20
2.80
2.40
110
100
90
80
70
60
50
40
30
20
10
0
70
60
50
40
30
20
10
% of + ve Ret 80% 60% 60% 60% 0% 40% 40% 20% 40%
2.00
1.60
1.20
0.80
0.40
Chart 6: 30y UKTi RY, NY & BE
30y Generic UK RY
30y Generic UK NY
30y Generic UK BE
0.00
Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10
Chart 7: UKTi Real, Nom ASW & Discount
20
10
0
-10
-20
-30
-40
-50
UKTI22 / UKTI37 Real
UKTI22 / UKTI37 Nominal Rhs
UKTI22 / UKTI37 Breakeven
-60
Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10
8: Front, 10y & 30y Real/Nom ASW Discount
0
Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10
Sources: BNP Paribas
UKTI13 R/N ASW Discount
UKTI22 R/N ASW Discount
UKTI37 R/N ASW Discount
5.20
4.80
4.40
4.00
3.60
3.20
70
60
50
40
30
20
10
0
Herve Cros/Shahid Ladha 16 July 2010
Market Mover, Non-Objective Research Section
42
www.GlobalMarkets.bnpparibas.com