Fears of QE-forever cycle turns spotlight on interest rate hedging
This sugar-high circularity is great when markets are buoyant but painful when they reverse
The runaway success of the German government’s €2.4bn 10-year Bund sale in March was yet another sombre reminder of the plight of defined benefit pension plans.
The issue attracted €6.3bn even though it offered a negative rate of 0.05 per cent, requiring investors to pay for the privilege of lending. Negative rates are back in the news, currently accounting for 11 per cent of global outstanding debt, according to Bank of America.
Falling rates in this decade have proved the Achilles heel of DB plans, holding more than half the retirement assets in the developed world. The reason is that, in the investment universe, interest rate risk carries no reward — only a double whammy.
Falling rates mean lower cash flows, as plans typically rely on bonds to fund regular payouts to their retirees. To cover the resulting shortfall, they have to invest even more.
Falling rates also inflate the present value of plans’ future liabilities, as calculated under the prevailing pension regulation. As a rule of thumb, a 1 per cent fall in rates delivers a 20 per cent rise in pension liabilities and a 10 per cent fall in the funding ratio — a measure of a plan’s ability to meet its future commitments.
In a typical pension portfolio, a lower discount rate tends to be net negative: its positive effect on equity assets is more than offset by the negative impact on liabilities.
Currently, just over half of DB plans have a hedge against falling rates. The holdouts, on the other hand, have hitherto believed that rates are at their all-time lows in almost all pension markets and are overdue for a rise. After all, stable levels of rates in mid-single digits have been the norm in previous centuries, always reverting to the norm after abnormal deviations.
This belief was also fostered by the much-telegraphed unwinding of the crisis-era quantitative easing by the US Federal Reserve, starting in December 2015. Having taken all the pain when rates were falling, the holdouts did not want to miss out on the upsides when the rate-hiking cycle finally started. Now, they are not so sure, due to two worries, one immediate and one distant.
The immediate one is the Fed’s recent decision to shift its rate cycle into lower gear. It set off alarm bells, coinciding as it did with 3.2 per cent growth in gross domestic product plus a booming jobs market in the first quarter of this year in the US.
Arguably, the Fed had no choice after the equity rout in the last quarter of 2018. True to form, the markets were yearning for more sugar highs, as they have done on many occasions in this decade. The decision showed that asset prices are now both the result of monetary action and a factor influencing it. The implied circularity is great when markets are buoyant but painful when they reverse. What was once a medicine has turned into a drug.
The Fed’s baby steps towards rate normalisation were welcomed by DB plans at the outset in the hope that it would eventually lead to upward pressure across the interest rate spectrum and reduce pension liabilities. It would also finally re-establish the conventional notions of fair value, mean reversion and equilibrium price. After all, investing in the age of QE has been akin to navigating by the stars.
Whether the Fed’s decision to pull back was in response to political pressure from President Donald Trump to slash rates and resume bond-buying to boost growth ahead of the 2020 general election is hard to tell. With the rise of populism, central bank independence is under threat on both sides of the Atlantic.
The more distant worry for DB plans is mounting global debt, now at $184tn, equivalent to 225 per cent of global economic output, up from a previous peak of 213 per cent in 2009, according to the latest estimate from the International Monetary Fund.
By definition, debt means consumption brought forward. Its repayment will remain a big drag on global growth. Interest rates have to remain lower for much longer to stave off bankruptcies among zombie borrowers and companies that face liquidity risk as their debt matures. Global growth has become overly debt-addicted.
This raises the spectre of a QE-forever cycle. History shows that debt crises never have a good ending, while taking decades to unwind after numerous twists and turns. The recent German Bund saga indicates what many have long feared: the “Japanification” of the EU economy where QE has struggled to reboot its spluttering growth engine.
Pension plans find themselves in an invidious position on interest rate hedging: damned if they do and damned if they don’t.