Last month, the Federal Reserve raised the Fed Funds Rate for the second time in eight years. The futures market expects two more increases in 2017 and a similar pace thereafter. Typically, increases in the Fed Funds Rate combat inflation by “putting the brakes” on economic growth. This time around, the prospect of higher rates is being viewed as a return to economic normalcy after years of unprecedented dominance by the central bank.
Corporate pension plan sponsors welcome higher rates, as they lower liabilities, thereby improving funded status. But, does an increase in the Fed Funds Rate also lead to higher long-term interest rates used to discount pension liabilities? The history of tightening of monetary policy shows only a modest impact on long-term rates, and the planned actions of sponsors may contribute to a ceiling on long rates.
The Fed Funds Rate has increased an average of 4.10% during the 15 times monetary policy has been tightened since 1965, while the 10-year Treasury yield has increased just 1.19% on average during the same periods. Almost half of that time, the yield curve inverted (with three-month Treasury yields higher than the 10-year Treasury note) during the tightening. While it is common to think of interest rate risk in terms of “parallel shifts” in the yield curve, history suggests flattening is the norm.
Another factor to consider: the future actions of corporate pension plan sponsors, insurance companies and global investors facing low and even negative yields locally. Looking specifically at plan sponsors, our Corporate Defined Benefit survey shows over 50% are using a glide path – a policy designed to increase the allocation to long bonds as funded status improves. We estimate that about half of the rest may be on an implicit glide path, waiting to de-risk and buy bonds when rates rise. This pent-up demand for long bonds, estimated to total trillions of dollars, may suppress long rates any time they rise.
To this end, we believe the anticipated and gradual increase in the Fed Funds Rate by an additional 1.50% may only raise long rates by 25-to-50 basis points. Please contact NEPC if you would like to examine how these dynamics apply to your portfolio.