Pension fund investors in the UK and Europe need to prepare for rising interest rates, according to experts—despite the two regions’ central banks seemingly being on different paths regarding short term policy.
Bank of England (BoE) Governor Mark Carney gave the clearest signal yet that the UK’s interest rate would likely rise from its record low level of 0.5% by the end of 2014, speaking at London’s Mansion House last month.
His comments pushed up the price of sterling against the dollar and UK 10-year government bond yields rose as investors sold out.
In contrast the European Central Bank’s (ECB) efforts to fight falling inflation have led it to cut its main interest rate to a record low 0.15% and the deposit rate to -0.1%, the first time the central bank has introduced negative interest rates.
ECB President Mario Draghi said last week that the bank was prepared to launch its own programme of quantitative easing—something Europe has until recently been reluctant to do—if conditions require, but expressed confidence that the ultra-low interest rates would boost inflation and help keep the fragile economic recovery stable. In June, eurozone inflation was just 0.5%, compared with the ECB’s target of 2%.
Colin Richardson, client director at Pitman Trustees, said UK pension funds were unprepared for an imminent interest rate rise despite a number of recent speeches by members of the Bank’s rate-setting Monetary Policy Committee.
“After this long period of unchanged extraordinary low rates it is vital for schemes to be prepared for the changes to come,” Richardson said.
He said schemes needed to pay close attention to duration risk in the short term, as markets were likely to move significantly based on predicted future rate rises. He added that de-risking strategies could also “become more active depending on base rate impacts on longer term yields”.
Bonds are expected to sell off once interest rates start to rise which, while negatively affecting asset prices, may allow some schemes to de-risk at a lower cost. Richardson said schemes should set out plans as soon as possible if the de-risking route is appropriate.
While UK pensions may be underprepared, Frank Driessen, chief commercial officer at Aon Hewitt in the Netherlands, claimed pensions based in the Eurozone were actively “hoping that interest rate levels will rise” soon as this will, broadly speaking, make for improved funding ratios for many pensions.
In contrast to the UK, however, Dutch pensions are prevented from “speculating” on interest rates through duration hedging, meaning any forecasts cannot be translated into investment policy.
Instead Dutch institutional investors will be forced to watch as markets are torn between two possible scenarios which are affecting interest rate forecasts, Driessen said. He argued that Europe’s return to growth should act to increase inflation, but while this growth remains weak and there is a lack of competitiveness, inflation could be driven lower.
Driessen added: “The economy will remain very volatile and recovery is difficult and fragile. Competitiveness reasons are driving inflation lower. Therefore interest rates will remain low.”
It may be only the economists who have paid attention so far, but rates should become more of an interest for investors sooner rather than later to avoid being taken by surprise.
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