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LDI market review and outlook
Elections and market reformcompeting for attention
Euro LDI | July 2024

Ying Yi Lovick-Tee
LDI Portfolio Manager
Whilst most central banks erred on the side of caution, reticent
to commence the monetary easing cycle in response to fallinginflation and slowing growth, the ECB was the first to take theplunge. With the downside risks to growth in Europe much higher
now given the political and fiscal uncertainty in France, as well
as a slowdown in German manufacturing growth, the ECB’s
deliberate vagueness on the path of easing has allowed it toretain optionality on future cuts. Our quarterly poll of investmentbank trading desks on a range of topical questions helps support
our narrative around market activity and outlook. Additionally,
we also discuss developments in respect of market reform,
specifically benchmark interest rates, and their potential impact.
The uncertain global economic and political picture due to theelections in the US, UK and Europe dominated markets over thesecond quarter of 2024. In terms of monetary policy, Europe was
the first mover with the ECB cutting interest rates by 0.25% at its
June meeting, but giving no commitment on the pace of future
cuts.
More specifically, France has been the centre of attention, firstseeing its credit rating downgraded at the end of May. Following
that, at the beginning of June, significant gains were made byFrance’s far right at the European Union parliamentary elections
at the expense of President Macron’s party. A snap election wascalled in response, to take place just after quarter end. The market
showed some concern with this unexpected decision, as 10-yearFrench government bonds cheapened c. 0.3-0.4% relative to 10year German bunds at the widest end of the range, but this was
not sustained, and the market was by no means in panic mode.
Market participants simply opted not to take any large positions

given the volatility as the French election played out. Now in theface of a hung parliament, the possibility of any one party wreaking
fiscal havoc has been eliminated, but the stalemate also meansno significant policy changes can be implemented. Meanwhile,liquidity in European government bonds has worsened given
French volatility, and investors continue to be cautious over any
overweight positions to France, in particular to French inflationlinked bonds where Germany’s decision to cease inflation-linked
issuance would have seen some build-up in French exposure,but also mindful of any potential spillover effects to valuations ofFrench sovereign, supranational and agency issues.
The ECB has stressed a reliance upon data and hence there is
the possibility of greater uncertainty around the path and pace ofinterest rates after the June cut and possible policy divergencefrom other western economies (most specifically the US), if others
remain reticent to commence monetary easing. The Fed’s “dotplot” indicates only one cut this year, but the market is pricing in
one or two more cuts in Europe. This differing forecast reflects
contrasting macroeconomic conditions, however, due to greater
perceived weakness in the EU economy which contrasts the US
economy’s persistent above-trend growth.
With policy rates kept on hold and rate guidance left unchanged
at the July meeting, the ECB’s president used language in thepress conference that bore similarities to that used to prepare themarket ahead of the rate cut in June. If data continues to support
the medium-term inflation outlook being disinflationary and if thegrowth outlook remains weak, then this paves the way for a 0.25%
rate cut in September, and potentially one more before the endof 2024.

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Euro LDI Survey – July 2024

Market Update
Apart from being the first mover in cutting rates, Europe is also
an outlier in terms of its primary interest rate benchmark – as it
continues to use Euribor – whilst most other developed market
countries have transitioned away from Interbank Offered Rates(IBORs) to Risk-Free Rates (RFRs). The robustness of Euribor as
the preferred benchmark index rate was questioned as it did not
respond as quickly as the Euro Short Term Rate (ESTR or €STR)
during the ECB’s hiking cycle, resulting in the ESTR-Euribor basis
turning negative (i.e. negative credit risk associated with banks).
Consequently, there is a consultation on the topic of Euribor
reform to ensure that the index remains credible and reliable as ameasure of banks’ cost of funding; as well as a possible change
to the European Insurance and Occupational Pension Authority(EIOPA) discount curve, which currently references Euribor as it
is “deep, liquid and transparent” (DLT). The latter is contingent on
the fulfilment of two criteria of “proximity” and “liquidity”, the firstof which has already been achieved. ESTR volumes have been
increasing and if they reach 50% of total traded volume in all tenors
across the curve, the liquidity condition will be satisfied to transition
the EIOPA discount curve from Euribor to ESTR. If the switch were
to happen, this could trigger a significant shift in LDI hedging fromreceiving fixed and paying 6-month Euribor to receiving fixed andpaying ESTR, thus widening the ESTR-Euribor basis, especiallyfor longer maturities. 6-month Euribor dominates across thecurve except for the front end (2-year and shorter) and as long as
it remains the standard for trading in the interdealer and broker
markets, the liquidity gap between both discount curves will persist.
In the absence of publicly available data for ESTR-Euribor split
by tenor, we polled our bank counterparties to get a sense of thecurrent market split and how this might be expected to change
in a year’s time. Compared to data published by EIOPA in July
2021, where the proportion of swaps-based hedging referencing
ESTR was c. 23% for maturities shorter than 15-year and c. 10%
for longer maturities, the market share for ESTR has continued togrow. Our counterparties’ responses indicate the median for ESTR
swaps hedging accounts for c. 44% at sub-15-year tenors and c.
25% for longer maturities; and is expected to rise further to 50%
and 28% respectively in a years’ time.

Chart 1: Swaps-based hedging referencing ESTR as discountcurve*
80%
70%60%
50%
40%
30%20%
10%0%
1 year ago

2Q 24< 15y1 year from now> 15ySource: Columbia Threadneedle Investments. As at 28 June 2024
*10 bank responses were included within this survey

Around 80% of our counterparties expect the liquidity in ESTR
to grow at both Eurex and LCH clearing houses, a change thatwill happen gradually. There is a regulatory bias for trades to becleared via Eurex – the European Commission’s European Market
Infrastructure Regulation 3.0 (EMIR 3.0) is under review – which
could result in prescriptive measures being introduced for thoseinvestors who are in scope to clear a minimum proportion oftrades via an EU clearing house (e.g. Eurex). Market flows driven
by said regulatory change could drive a wedge between levels toclear ESTR-based swaps via EU and via non-EU clearing houses,
thus presenting another opportunity where investors could takeadvantage of the differential arising from shifts in liquidity.

2Euro LDI Survey – July 2024

Market Outlook
We also asked investment bank derivatives trading desks for theiropinions on the likely direction of key rates for pension scheme
liability hedging.
The results are shown below as the number of those predicting arise less those predicting a fall, as a percentage of the number ofresponses. The larger the balance, the more responses predict arise. The more negative the balance, the more responses predict afall.
Chart 2: Change in swap rates over the next quarter**
120%

Balance (rise–fall as % of total)

100%
80%
60%
40%
20%
0%-20%-40%-60%

EUR 30Y Swap Rate
EUR 30Y (swap) real yield

EUR 30Y HICPx Swap Rate

Source: Columbia Threadneedle Investments. As at 28 June 2024**15 bank responses were included within this survey

Q3 24

Q1 24

Q3 23

Q1 23

Q3 22

Q1 22

Q3 21

Q1 21

Q3 20

Q1 20

Q3 19

Q1 19

Q3 18

Q1 18Q3 17

Q1 17-80%

In the prior quarter our counterparties expected a fall in all threemetrics, with high conviction on all, in particular on the nominal
swap rate. This proved to be wrong. There was consensus that aJune rate cut would be announced, and although this did occur, it
was not enough to offset the bond sell-off (which caused yields torise). Long-end swap yields rose due to continued heavy supply,
albeit not as sizeable as seen at the start of year. The reliable flowof Dutch pension scheme buying, usually receiving at the long end,
saw reduced volumes, and was therefore insufficient to offset theleg higher in swap rates.
Looking ahead, our counterparties have even greater conviction in
calling for a fall in all three metrics by the end of the third quarterof 2024 (the highest conviction seen in many years for a fall in the30-year swap yield). The market has priced in a high probabilityof a September rate cut, with continued weakening global anddomestic data supporting this narrative. That said, many remain
cautious despite the strong conviction on the call for lower yields
as there is potential for term premia to reprice strongly, consequentof political uncertainty in France (and hence its ability to effectively
consolidate its debt, thus facing a further credit downgrade) andthe major risk event of the year that is the US election. As we go
into the summer months, EU issuance is set to slow and LDI buying
likely to take a pause, hence there is potential for longer-dated
yields to fall as our counterparties expect by the end of the third
quarter of 2024.
In inflation, there continues to be a view that long-end inflationis structurally too high; and with falling inflation expectations,our counterparties broadly expect a fall in the inflation rate. Itis noted that with French real yields and inflation volatility likely
staying elevated in the near term, it will not be surprising if market
participants close out positions / avoid initiating new positions
in European inflation (bonds or swaps) until fiscal and politicaluncertainty normalises.

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Euro LDI Survey – July 2024

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