The risk of losing in the growth war also came starkly into focus in early August when Mario Draghi failed to outline measures to support the eurozone. After Draghi promised in late July to do everything possible to support the euro, the risk-on mood swing caused an immediate euro surge by 1.6% versus the dollar to 1.24. Had the European Central Bank (ECB) delivered on expectations, the risk-on mood would have strengthened, pushing the euro higher against the dollar.
That outcome is highly undesirable for export- dominated countries like Germany, whose central banker, Jens Weidemann, was very vocal in warning the ECB not to overstep its mandate. Germany is strongly opposed to a resumption of the ECB’s bond buying programme or granting a license to the European Stability Mechanism (ESM) rescue fund, two of the strongest options for supporting the euro. The euro lost over 200 pips versus the dollar to below 1.22 during the ECB press conference on 2 August alone.
More international intervention remains likely in the face of the continued eurozone crisis, which has the potential to worsen again, momentum in the US economy could flatten or reverse in light of the upcoming fiscal cliff and Chinese growth remains a concern.
In a growth war that hinges on relative factors such as exchange rates, pressure will continue to mount on the BoE to loosen monetary policy further in the coming months and quarters. As well as further QE, that looks likely to include a cut in the UK base rate from its already historic low. The market is pricing in a cut come November based on current inflation expectations.
“If inflation does fall further as is expected, the BoE may well decide to supplement its policy of putting more money into the market QE with the provision of cheaper money by lowering rates further,” says Lloyd Raynor, senior consultant at Russell Investments. A decrease in base rate would further compress yields.
According to Robert Gardner, co-chief executive of investment consultancy Redington: “It is not improbable that rates will decrease, which would pull the yield curve lower, reinforce the increase in liabilities and produce a further fall in funding levels. That, in turn, will increase the pressure on corporate balance sheets.”
The impact on corporate balance sheets, and subsequently economic growth, caused by the lower yields for pension funds has yet to be fully appreciated by policy makers. Mark Gull, co-head of asset-liability management at Pension Corporation argues the increased pressure on corporate sponsors would cause “real damage” to the economy.
“As deficits increase, money flows out of corporates into pension funds rather than being invested in the real economy,” he says. “Many policy makers don’t fully recognise the implications of the current form of quantitative easing on pension funds and, therefore, the wider economy.”
Between a rock and a hard place
Yet, there is little institutions can do to protect themselves from the QE onslaught and safety-seeking in UK bonds. They are largely hostage to these events, particularly policy effects. Segars says: “The answer to this conundrum lies less with institutions than with regulators. Pension funds are a forgotten part of the equation. No one has really thought through the effect on them.”
Lobbying policy makers is a keen focus area for organisations such as the NAPF and Pension Corporation, who want recognition of the damage current intervention is causing and are attempting to steer policy makers towards other, more creative, forms of QE that would be less damaging for scheme deficits and potentially more successful at generating much-needed growth.
The NAPF and Pension Corporation have both been calling for a move away from buying gilts to buying assets such as high-rated corporate bonds, infrastructure or bank loans.
“Printing money is subject to the law of diminishing returns,” Pension Corporation’s Gull says. Instead, the BoE should consider targeting infrastructure assets in the form of bank loans and sell them on to institutional investors, which would benefit from long-dated assets offering better yields that are a better match for their liabilities. “That would be a more sensible way to utilise money creation,” Gull says.
This approach could also lower DB schemes’ deficits by over £40bn, easing the pressure on corporate sponsors and avoiding further compression of gilt yields.
According to Chris Iggo, chief investment officer of fixed income at Axa Investment Managers, with monetary policy likely to be loose for some time investors should look at opportunities for accessing higher yields while minimising the additional risks. “The obvious alternative for investors is short duration investment grade corporate bonds where the yield differential versus gilts is around 2% to 2.5% in Europe and around 3% in the UK,” he says.
However, ultimately, all schemes can do to avoid further damage to funding levels as a result of intervention is to join the debate. “It lies with the regulators to think through creative solutions, such as interest rate floors for discount rates,” Segars says. “We need that creative thinking.”
In a call to action among its members, Segars stresses the importance of coming together to suggest creative solutions. “We are looking to our members to do modelling of the different possibilities and think through the regulatory options and their implications,” she says.
With Western de-leveraging expected to last many years yet and a secular slow-down taking hold in major emerging markets, an end to the growth war is unlikely to come soon. As the victims of that war, UK institutions need to look at ways to protect themselves from the onslaught of intervention. That means increasing the pressure on policy makers to consider alternative fire-power, but also a rethink on whether gilts are the best way to match liabilities if they are subject to manipulation.
Self-victimisation: is there an alternative?
The Bank of England is not the only culprit in pushing down yields. UK institutions have had a very significant impact through their continued trend toward de-risking and their appetite for safe-haven assets.
“Investors are willing to pay up to hold gilts at negative rates,” Redington co-chief executive Robert Gardner says. “Further compression of UK yields are less likely due to QE and more about further bad news out of Europe.”
Despite record-low gilt yields, National Association of Pension Funds’ research shows institutional demand for UK gilts is unlikely to decrease as nearly one in five defined benefit pension schemes polled in March said current market conditions would push them further towards gilts and de-risking strategies.
The risk-off mood sparked by Draghi’s failure to come up with solid measures to support the euro in early August saw yields on benchmark 10-year gilts fall during the first week of August from 1.54% to 1.49% and 15-year gilt yields contracted from 2.2% to 2.15%.
The question institutions are being urged to consider is whether gilts are really the best liability-matching tool in a period that is seeing significant intervention. PwC chief actuary Raj Mody believes the idea that gilts are the best assets for matching liabilities is an “accepted myth”, while QE is distorting what gilts stand for.
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