With central banks engaging in quantitative easing programmes, changes in government bond yields across developed markets have become increasingly correlated. For UK pension schemes, with sizeable allocations to government and corporate bonds, monitoring monetary policy around the world is important as market reactions can trickle into global bond markets. To that end, Fed Chairman Powell’s recent remarks are of particular interest. We concur that, at a minimum, the recent sharp rate moves and evolving perceptions of the possible reactions of Central Bankers to these moves bear careful monitoring.

Record peacetime stimulus was implemented over 2020 and there appears to be no let-up in sight. The US passed a $1.9 trillion stimulus package bringing total pandemic fiscal stimulus to nearly $6 trillion (25% of GDP). ECB officials are hinting at increasing PEPP (Pandemic emergency purchase programme) purchases, if rates which are still in negative territory rise further.

Covid-19 vaccination programs are underway, although everything has not gone smoothly as expected, by late summer some 70% of the population of major developed markets are expected to have received at least one dose. While the speed of the recent rate adjustments is concerning, with macro forecasters revising their expectations for 2021 global growth upward, it is not surprising that real yields are rising from their historic lows.

US Analysis

Source: Bloomberg

We believe a significant portion of the recent rise in both real yields and inflation has been supported by fundamentals as the market began repricing its perception of the Fed’s neutral rate from 1.75% in January to closer to 2.25% as of 5 March 2021. This is nearing the Fed’s long run estimate of a 2.5% neutral rate. As illustrated by the chart above, inflation expectations and real yields decreased dramatically in the first half of 2020 with worsening economic prospects. Inflation expectations increased over the second half of 2020 while real yields continued to fall. However, the recent change in yields has also been driven by a rise in real rates – up 0.4% from 10 February 2021 to 5 March 2021. Powell suggested we’ve had a healthy increase in real yields with the improving economic outlook. However, it is a fair concern that a sharp rise in real yields might lead to decreased spending/higher savings and a stronger dollar, leading to potentially tighter financial conditions.

UK Analysis

On 18 March, the Bank of England (BoE) upgraded its outlook for the UK economy but made it clear that there would be no rush to reduce the support and stimulus it was providing to boost the economic recovery following the Covid crisis. Over the year to date UK gilt yields have risen however, the BoE confirmed this was largely warranted due to the improved prospects for recovery.

Source: Bank of England

Whilst the yield curve moves may appear extreme, we believe the rise is a reflection of a more favourable economic outlook rather than concerns around excessive inflationary pressure, which is consistent with the BoE. Furthermore, the BoE stated that they would not consider tightening monetary policy until the Monetary Policy Committee (MPC) was sustainably achieving the inflation target of 2% p.a.

Looking at the rhetoric from US and UK central banks, leads us to conclude that whilst we may seem some justified increases in yields, central banks look set to maintain a lower for longer approach to interest rates. Indeed, the trajectory of the BoE’s current quantitative easing programme will leave the BoE with £895bn of assets accumulated since 2009.

What does this mean for UK Pension Schemes?

The rise in yields will affect UK pension schemes in different ways, depending on strategic choices. For schemes with high interest rate and inflation hedge ratios, the rise in gilt yields will not have impacted their funding materially.

Those with low hedge ratios may see an improvement in funding, as the value of their LDI portfolios will have fallen less than their liabilities. These schemes may want to question their investment advisor/fiduciary manager about the opportunity to reduce some interest rate and inflation risk.

Pension schemes who have allocations to corporate bonds may find that whilst they have seen some mark-to-market losses, the higher absolute yields represent an opportunity to rebalance portfolios and improve potential for future total returns within bond portfolios. A good investment advisor/fiduciary manager will be pro-active in taking advantage of these scheme specific opportunities.