Who’s afraid of the RPI-CPIH judicial review?

RPI trading booming as market ignores legal challenge to the transition

The UK inflation market is unique in that the parties divide very cleanly into those that need to receive it and those that need to pay it away.

Receivers, such as pension funds, often need to receive inflation in order to hedge future liabilities that are linked to it. Meanwhile payers, often corporates, have revenues linked to inflation that they want to pay away as a hedge.

So if you change the inflation benchmark to one that is around 1% a year lower – as the UK is planning to do after 2030 – pretty much all pension funds holding assets where they receive cashflows linked to inflation will be upset. With analysis from the Association of British Insurers showing the move could cost pensioners £96 billion ($136.1 billion) by 2030, there’s always a risk that like-minded funds might club together to try and stop the move.

In April, that’s exactly what happened. Trustees of pension funds at Marks and Spencer, Ford and BT lodged a judicial review seeking to challenge the UK’s planned recalibration of the retail prices index (RPI) to the consumer price index including owner-occupiers’ housing costs (CPIH).

RPI has been the UK’s main inflation index since 1956, but has long been seen as a flawed measure. Instead, the UK Statistics Authority has since championed CPIH as a more accurate calculation of inflation than RPI, and in November 2020, the UK Treasury confirmed that RPI would be converted into CPIH after 2030.

The trustees – which together represent nearly 450,000 members and £83 billion in assets – argue that the UKSA lacks the authority to recalibrate RPI and that both it and the government failed to take into account the recalibration’s impact on legacy RPI users when reaching their decision in November.

If successful, the judicial review could lead to changes being made to the government’s current RPI reform plans, such as the date it takes place and whether any form of compensation will be given to market participants set to lose out from a lower rate of inflation – something the government has previously mooted.

That uncertainty might sound worrying if you’re a trader thinking about putting a new inflation swap on right now. But current market pricing shows that traders don’t expect the legal challenge to be successful.

Toby Huth-Wallis, an inflation trader at Nomura, says that if the transition were fully priced in, the future difference between RPI and CPI – known as the wedge – would converge to zero at the 2030 point.

These levels are sensitive to transition announcements. Before the November announcement that 2030 would be the date for RPI transition, that forward wedge sat at -25 basis points. It changed to -10bp after the 2030 date was confirmed. There has been no obvious movement that could be linked to the news of the judicial review, says Huth-Wallis, indicating a lack of concern from the market.

In fact, now that the 2030 transition is priced in, traders say longer-dated RPI trading has picked up considerably due to the rise in lumber and iron ore prices, the ongoing Brexit trade frictions and pent-up demand from liability-driven investment managers that had put off some of their inflation trading until the 2030 date was confirmed.

If the judicial review is successful, and RPI receivers could continue to receive higher inflation cashflow payments than were factored into the price at the outset, it would be seen as a cherry on the top, rather than a key part of the trade’s rationale.