QE a Double-Edged Sword for Institutional Investors

The Federal Reserve’s August 1 meeting could bring news of a fresh round of quantitative easing, something that could bring ecstasy to markets but some pain to institutions investing against liabilities.

(July 31, 2012) — A Federal Reserve meeting on Wednesday could cause markets to surge at the same time it sparks consternation for certain institutional investors.

The Federal Open Markets Committee (FOMC) meets on August 1 and some are speculating that the Federal Reserve could use the occasion to announce a fresh round of quantitative easing (QE). Though monetary stimulus may not be forthcoming Wednesday, certain institutional investors have mixed expectations about it, underscoring the conflicting tensions affecting their fund integrity.

While “QE initiatives that improve equity returns are obviously helpful to pension funds,” explains David Service, director of Towers Watson’s investment consulting arm, falling Treasury yields increase their liabilities. As a result, he says, “how the QE would be delivered and how it affects the two markets is therefore critical” in the eyes of pension plans.

Many institutional investors, particularly pension and insurance funds, invest against liabilities, which are calculated using benchmark interest rates. When interest rates are low, as they have been since the 2008 financial crisis, liabilities spike and underfunding grows. In countries with relatively sound fiscal positions, such as certain Northern European nations and the United States, capital seeking “safe” sovereign debt has depressed interest rates so much that regulatory rules have been changed to ease institutional investor pain. QE by central banks can exacerbate those already inflated liabilities even further; some have even gone as far as accusing the Federal Reserve, for example, of “destroying pension funds.”   

At the same time, QE can rouse equity markets, raising performance for the portfolios of institutional investors. When central banks lower interest rates, capital floods into equities as investors chase returns. Last week, markets surged after the president of the European Central Bank vowed to do “whatever it takes” to preserve the Eurozone, an allusion to what many investors took to mean as a willingness to purchase Spanish and possibly Italian sovereign debt.

Data last week revealed that the US economy had grown a tepid 1.5% from April through June, deepening fears of a possible recession and fueling expectations that the Federal Reserve would take action.