Pensions' Massive Bet on Rising Rates?
Most pension plans have long-dated liabilities and much shorter-dated assets. In effect, their structure replicates the classic buy-short-sell-long trade: a trade which amounts to a bet on rising interest rates.
The scale of that bet can be illustrated by looking at how the pension deficit has grown in the past four years at some of America’s largest corporations – we call them the $20 billion club¹. At the end of financial year 2008, the 19 club members had a combined pension deficit on their balance sheets of $136 billion. In the ensuing four years, those corporations made cash contributions of $100 billion; that’s $48 billion more than the value of the new benefits that accrued. The plans earned double-digit returns on their investments; investment returns exceeded the interest cost on liabilities by $108 billion. Yet still the pension deficit rose by $84 billion to $220 billion. That happened because of interest rates. The falling rates of recent years have cost pension plans dearly.
Today, faced with the expectation of a rising rate environment, many corporate pension plans are holding off on fully committing to LDI. The bet on rising rates remains enormous.
But it may well be a bet with the odds stacked against it. In part, that is because it is not enough rates rise for the bet to pay off: there is a break-even hurdle to overcome before the position makes a gain. That hurdle is captured in the forward curve.
As shown in the chart above (click on image) – which is taken from Russell’s latest monthly LDI update – the forward curve is currently pricing in substantial increases in rates over the next few years: around 1.2% over the next three years on the 10-year rate, for example, and over 2% for the 2-year. Rates would need to rise to levels above each of these break-even forward curves for the bet on rising rates to pay off.
Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.
What’s more, investment theory and historical experience point to the existence of a term premium, which would make a bet on rising rates even less likely to succeed. The term “premium” refers to market pricing tending to favor the holders of long bonds over short, a reflection of the risk preferences of investors in aggregate. That’s why over the past twenty-three years, the forward curve has built in an increase in rates almost 90% of the time – even though that was a period when rates actually fell significantly. A term premium means that a bet on rising rates can be expected to make a loss more often than not, even in an environment where rates are expected to rise.
So the pay-off to a bet on rising rates is negative unless the forward curve break-even point is reached. Of course, rates can, and sometimes do, rise quickly. But a bet on rising rates is one that has historically had the odds stacked against it and investors ought to be wary before assuming that a rising rate environment means easy gains.Go back to read my comment on why pensions are ill-prepared for a rough landing where I discuss how quantitative easing may eventually reinforce deflationary headwinds, especially if asset bubbles pop, hurting the real economy. I also referred to Hoisington's second quarter outlook which begins by stating "the secular low in bond yields has yet to be recorded."
One of the things Hoisington refers to is the favorable inflation backdrop. In fact, a couple of weeks ago, a survey by JP Morgan found inflation expectations dropped to their lowest level since 2010:
Investor expectations for U.S. inflation have declined to the lowest in more than three years even as data point to economic recovery, JPMorgan Chase & Co., said, citing surveys.So why are investors betting on rising rates if they see no inflation on the horizon? Is it due to fears of a bond market dislocation once the Fed starts tapering or is it because of fears of a run on the U.S. dollar? I don't know but without inflation, it's hard to make any case for a substantial rise in interest rates. And without strong and sustained jobs growth, I don't see inflation expectations picking up a lot over the next couple of years. (Note: if you want to know where rates are heading, read Brian Romanchuk's comment on the world's simplest bond valuation model).
While policy makers in major economies are providing unprecedented stimulus, investors see little price pressure in the U.S., the euro region or the U.K. over the next five years, according to the bank’s quarterly overview published yesterday.
Investors expect U.S. inflation to average 1.68 percent in the next 12 months, compared with 1.85 percent in the previous survey in March. Over the next two-to-five years, the rate is seen at 2.4 percent, the lowest since the July 2010 survey, JPMorgan said. The report was based on responses from 320 investors including asset-management companies, pension funds, banks and hedge funds.
Medium-term inflation expectations for the euro region dropped to the least since the surveys began in March 2010, with investors predicting consumer prices will increase at a 1.3 percent rate in the next 12 months and 2 percent in the two-to-five-year horizon.
One place where inflation is a problem is China. Below, Veracuz TJM Founder Steven Cortes discusses China’s waning exports and rising inflation. He speaks with Trish Regan on Bloomberg Television's "Street Smart."