Investors in UK inflation-linked bonds are facing two critical sources of structural uncertainty: volatility arising from the Brexit process, and questions about the deeply entrenched (yet problematic) Retail Price Index (RPI), to which UK “linkers” are tied.

Navigating these uncertainties – and the pricing dislocations they may produce – requires a thoughtful and responsive investment approach that aims to sidestep risk while seizing opportunities that may arise.

Brexit-related volatility persists

On 23 June 2016, as the results of the UK referendum to leave the EU were revealed, markets sought an equilibrium in a highly uncertain scenario. The pound weakened, leading to higher breakeven inflation expectations (see chart). Notably, breakeven inflation has remained elevated, indicating that uncertainty persists and markets remain far from a stable destination. Just last week, British lawmakers rejected the proposed Brexit deal for a second time, while also rejecting a no-deal outcome and approving a motion to postpone the Brexit date. Though hurdles remain, the base case seems to suggest an extension of the current 29 March deadline, which would likely result in lower breakeven inflation over the short term.

Regardless of the near-term parliamentary debates’ outcome, we should not forget that the real negotiations about the UK’s relationship with the rest of the world have yet to begin, and will likely last for years. The final impact on tariffs, currency movements and monetary policy could spur large moves in breakeven inflation in both directions, requiring a dynamic approach to managing positions in inflation-related assets.

RPI policy shifts move markets

Ongoing questions about the Retail Price Index present another source of uncertainty. Despite the RPI’s broad use, in products ranging from inflation-linked gilts to student loans to regulated tariffs, its methodology does not meet international standards, and the UK’s Office for National Statistics has not classified it as a "national statistic" since 2013. Moreover, methodological differences have created a persistent gap between RPI and the UK Consumer Price Index, the measure used for setting monetary policy (and which does meet international standards). The RPI methodology tends to bias higher results relative to UK CPI (the current gap is 0.7%), and differences in basket weightings and definitions, particularly for housing components, can contribute to large discrepancies between the indexes when mortgage rates move.

These realities suggest a structural underweight bias to RPI breakevens, given that while discontinuing the RPI would be no simple task, policymakers have periodically proposed changes to its methodology – and markets have taken notice. UK 10-year breakeven inflation expectations declined almost 10 basis points (bps) in the days following publication of the House of Lords’ January 2019 report, in which it urged the unwinding of a 2010 methodology revision that has pushed inflation prints roughly 30 bps higher. Such shifts highlight the importance of monitoring RPI debates and underscore the potential benefits of an active approach to UK linkers, given the market’s idiosyncrasies.

Uncertainty calls for an active approach

While the base case scenarios for both Brexit and RPI changes recommend underweight positions in breakeven inflation, the potential for “tail” scenarios in either direction – and the need for active management of positions at the margin – must be acknowledged. Uncertainties in the large and important UK inflation-linked bond markets are likely to persist for some time, and we believe investors seeking to gain from market inefficiencies while avoiding downside risks may benefit from an active approach. Managers with the experience and resources needed to monitor and respond to index and market dynamics while also heeding critical governance and political developments may offer an advantage – and we believe outcomes could look very different for active versus passive or static approaches in the coming years.

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