Approaching the summit in UK rates? Implications for DB schemes

Have we reached the peak?

After more than 500 basis points (bps) of rate hikes in less than two years, last month saw the Bank of England (BoE) keep rates on hold on a very tight vote of 5 to 4. As mentioned in Chris Jeffery’s blog, historical data suggest that 5-4 votes often come at inflection points for monetary policy, indicating that the end of the hiking cycle may be in sight.

Meanwhile, recent economic data suggest that higher rates are now having an impact. We are beginning to see signs of labour market loosening and leading economic indicators (PMIs) suggest business conditions are deteriorating.

Unless the next set of economic data is stronger than expected, we believe there is a good chance that we are very close to the end of this rate cycle. The market is currently pricing around a 40% chance of a hike at the next Monetary Policy Committee (MPC) meeting in November, and another 20bps to the terminal rate.

Apart from the Bank of Japan, which has so far kept its policy rate unchanged, the BoE’s other developed market peers are at a similar stage in their rate hiking cycles. The Federal Reserve (Fed) also kept rates on hold while indicating that there could be one more hike this year.

Although the European Central Bank (ECB) did deliver a hike the week before the BoE, its messaging suggested it is now at levels that may be sufficient to bring inflation back to target. In other words, unless inflation surprises to the upside, it should have reached the end of its hikes, in our view.

So, even if we are not quite at the summit for rates for this cycle, we believe it looks like we are close.

What does this mean for pension schemes?

Gilt and linker (index-linked gilt) yields have risen alongside the hiking cycle and are currently around similar levels to where they were in the years prior to the global financial crisis.

For DB pension schemes that have not fully hedged their liabilities, the rise in yields is likely to have led to an increase in funding levels as liability valuations are likely to have fallen more than the value of their hedging assets.

This potential improvement to funding levels may put schemes in a better position to increase hedge ratios, and with yields at their highest in over a decade, we believe current levels look potentially attractive to lock in.

Moreover, our economists are forecasting a US recession to occur in the first half of next year, while current consensus and market pricing are for a soft landing. Our base case is that there will not be any further hikes from the BoE, the ECB and the Fed, and instead the Fed will cut rates by 200bps from here by the end of 2024 – far more than is currently priced in the market (c. 65bps from current levels).

Although it may take some time for the first cut to come, once the Fed starts we think cuts are likely to be large in size and rapid in pace. If this materialises, global yields could fall quite materially from current levels.

In this event, funding levels could decrease for schemes that have not fully hedged, and hedging would also be likely to be more costly at lower yields.

As such, we think that current gilt and linker yields are attractive, and for underhedged schemes that have benefited from the rise in funding levels, current levels could offer a good opportunity to lock any potential surplus.