The recent decline in yields is a sign of how quickly market expectations can change. While the UK base rate has remained at 0.75% since August 2018, longer dated rates have recently been falling fast. Between April 2019 and August 2019, the UK 10-year government bond rate has fallen from 1.27% to 0.52% and 20-year rates from 1.77% to 1.11%. This will have dramatically increased pension scheme liabilities unless they have been fully hedged.
Global decline
It is not just the UK where rates have seen dramatic declines - it is happening across the globe. The 10-year US Treasury yield fell from 3.24% in November 2018 to 1.69% in August 2019, with a 0.38% fall in the last few weeks alone. This huge decline can be explained by the US Federal Reserve reducing its benchmark rate by 0.25% on 31 July (the first reduction since 2008) and also deciding to end the process of shrinking its balance sheet, known as quantitative tightening, two months ahead of schedule. PIMCO estimates that $14 trillion in government bonds, or 25% of the global government bond market, has negative yields. In early August 2019, German 10-year yields were -0.58%, and the Japanese 10-year yield was -0.22%. Large bond managers say it would not be impossible for the US Federal Reserve to reduce rates to 0%; they are currently 2% to 2.25%. It seems unlikely that UK rates will go as low as Germany or Japan, but it highlights that investors are willing to accept negative returns in government debt.
Monetary policy driver
The driver of the recent declines is changing central bank monetary policy. Global central banks have started to reduce interest rates due to slowing economic growth and investors are pricing in more rate cuts. Recently, India, New Zealand and Thailand surprised investors with larger than expected rate cuts. Investors are becoming more concerned about global growth, particularly in light of the US/China trade war which is showing no sign of ending and is beginning to develop into a currency war. Investors are worried, which is leading to declines in equities, more flows into safe-haven fixed income assets and depressing yields even more. A popular recession indicator is the yield spread between US 10-year and 3-month Treasuries. It has turned negative before every recession since the Second World War and has been negative since May - so investors could have good reason to believe a recession is likely. A key tool central banks use to encourage growth when there is a recession is to lower rates. But considering how low rates currently are for developed economies, they will not be able to pull this lever and will need to find alternative solutions to avoid a prolonged recession.
So – just how low can rates go?
No one knows. We are in a period of low but stable global economic growth (except for the UK) with high employment - central banks are beginning to reduce rates to prolong the business cycle. Therefore, when the next recession occurs, central banks will cut rates even more. We may not have seen the bottom yet. The recent decline in yields poses a question for pension scheme trustees. Should they increase the level of interest rate hedging even though rates have fallen? This has been a key challenge for trustees over the last 10 years as rates have declined. While hedging won’t offer the same benefits as it did previously, because yields are lower, it should provide trustees with a more stable funding level.