By David Rae
Carney’s conundrum continued to play out on Wednesday of this week. First off in the morning, we saw better than expected jobs and earnings data released. Both headline and core average weekly earnings surprised to the upside. This was the third month in a row of upside surprise on earnings growth in the UK.
The headline International Labour Organization (ILO) unemployment rate remained at 6.0% in September. Together, these data releases point to slack being used up in the economy and the potential for wage pressures to build.
Later in the morning, we had the publication of the Bank of England’s Quarterly Inflation Report (QIR) accompanied by governor Carney’s press conference. The market latched on to the potential of inflation falling below the 1%year on year level at which Carney has to write to the Chancellor of the Exchequer. The key drivers of the lower inflation forecast remain imported inflation (oil and commodity prices and eurozone weakness).
Will a letter to George really make a difference? The market is now pricing in the first rate hike in Q4 2015. The Bank of England says the date of the first increase in Bank Rate will “move around” and be “data dependent”. We expect to see continued volatility in interest rates as Carney’s conundrum plays out. While Carney and the MPC will have to decide when to battle the strong domestic conditions and inflationary pressures, there are clear reminders in the QIR that the driving forces of the UK inflation profile and monetary policy evolution are external factors.
For pension funds with long-dated liabilities, changes to the near term inflation profile and short interest rates are less important than what happens at the long end of interest rate and inflation curves.
We continue to see opportunities for pension funds to increase inflation hedging in the current environment. The recent inflation undershoot is likely to be transient in nature. The one-off impact of lower energy and food prices along currency effects will roll off during 2015, beginning to push up year over year inflation prints. Coupled with increasing inflation prints, the supply of long-dated inflation, in the form of index-linked gilt issuance will reduce. By contrast, there will be no abatement in demand for inflation hedging by pension funds.
Having been in a declining trend, interest rate volatility has increased recently at the long end of the curve and this is likely to persist. As economic growth conditions continue to differ across the world and monetary policy follows increasingly divergent paths, we can expect to see more volatile interest rate conditions persist.
There are few people, if any that expect a return to the environment of 2% real yields but similarly real yields of negative 0.4% or lower across the full yield curve appear expensive given domestic conditions. There is scope for interest rates to rise from here, but it will be a bumpy ride. For pension funds on a journey to increased liability hedging, there are and will continue to be opportunities for nimble investors to benefit from the changing shape of the yield curve. Active positioning of interest rate exposures across the curve offers an attractive risk-adjusted return opportunity.
Outside of the traditional liability hedging arena, there are few asset classes that offer stellar return opportunities. We continue to look across both traditional and non-traditional asset classes to generate returns and manage risks. Success will be driven by the ability to identify attractive opportunities in a low-return environment and efficiently gain access in a risk controlled fashion.
David Rae is head of LDI solutions at Russell Investments
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