Low for longer (but longing for higher) rates

After the European Central Bank cut its deposit rate on December 3, the Fed went in the opposite direction based on its economic outlook for the US. 

“Room for further improvement in the labour market remains, and inflation continues to run below our longer-run objective. But with the economy performing well and expected to continue to do so, the [Federal Open Market] Committee judged that a modest increase in the federal funds rate target is now appropriate, recognising that even after this increase monetary policy remains accommodative,” the Fed’s chair Janet Yellen said on Wednesday.

The Fed will push fund rates to 0.25-0.5 per cent from previously 0-0.25 per cent. While the move could increase pressure on the Bank of England to follow suit, markets are not expecting a hike to happen before later on next year. 

You can’t wait for rates to come back to 4 per cent because you’ll be waiting a very long time, so you have to refocus and rethink what the right framework to operate in is

Neil Davies, Barnett Waddingham

Salman Ahmed, chief strategist at Lombard Odier Investment Managers, said: “One key difference is UK inflation is much lower than US inflation. And I think that means that they will have to be more cautious and that’s exactly what the Bank of England has been saying as well.”

The consumer price index rose by just 0.1 per cent in the year to November, Office for National Statistics figures showed. 

Trustees accept lower for longer 

Neil Davies, associate at consultancy Barnett Waddingham, agreed rates in the UK would remain unchanged until later next year, adding he does not expect a future rate rise to have any effect on schemes beyond “a little bit of volatility” around investment markets.

“Because it’s been so forewarned, everyone’s expectations will have been aligned with what’s going to happen,” he said, noting that the expectations of gilt yield movements are already pricing in rate rises in 2016. 

He said trustees have resigned themselves to the fact that low interest rates are the ‘new norm’. 

Schemes are therefore more willing to look at what needs to be done to generate returns in such an environment and revisit trigger rates for hedging increases, he added. 

“You can’t wait for rates to come back to 4 per cent because you’ll be waiting a very long time, so you have to refocus and rethink what the right framework to operate in is.” 

‘Agnostic’ about market prices 

However, Calum Cooper, partner and head of trustee DB at consultancy Hymans Robertson, said the only thing that would really help UK schemes reduce liabilities is for rates to rise either sooner or to higher levels than markets have priced in – but warned pension schemes not to bet too much on it. 

He said: “The average UK scheme is betting 50 per cent of their liabilities on that, which is £1tn of uncovered interest rate risk. When you compare how much return you expect to get for taking that position versus investing in income assets or even low-volatility growth assets, a lot of folks are tilting away from the interest rate risk and seeking reward where they have higher conviction.” 

This would mean reducing growth assets from their current levels and finding returns “a bit like an insurer would” in areas such as illiquid assets. 

Cooper added: “If you can hold them to redemption, buy-and-hold bonds, you’re sort of agnostic about market prices, you’re focusing more on cash flows and increasingly using levers of LDI to get more interest rate and inflation protection.” 

But Alex Koriath, head of European pensions practice at consultancy Cambridge Associates, said whether you buy-and-hold or not depends on the type of mandate you have.

“Most corporate bond mandates are shorter-dated, and by the nature of the benchmark stuff falls out,” he said.

“If you have long-dated government bonds to match liabilities then there is a desire to hold these cash flows to maturity.”