1 3 52 4 6 7
LDI and Overlay
Liquid and Semi
Redington designs, develops and delivers investment strategies to help pension funds and their sponsors
close the funding gap with the minimum level of risk. We take our clients through a rigorous 7 Steps to Full
Funding™, which begins with laying out clear goals and objectives and assigning tasks and responsibilities.
The second step is building an LDI Hub, or putting in place a risk management toolkit. Steps 3-6 involve
crafting the right investment strategy to fit the need using a full range of tools and bearing in mind the
goals and constraints of the scheme. Finally, ongoing high quality monitoring is essential to continually track
progress against the original objectives and guide smart and nimble changes of course.
The 5 Global Challenges 3
VUCA – The Acronym Of Our Time 4
LDI: Hedge Your Bets 2 5
Inflation Risk: Mind the Cap (and Floor) 2 6
Don’t Discount the Effect of Discounting 2 7
Investment Grade Credit, Or Is It? 3 8
Setting Trends By Following Them 3 9
Saving Mean From Meaningless 3 10
Meeting Industry Challenges Head On 7 11
When Unconventional Becomes Traditional 1-7 12
Further Information and Disclaimer 13
O U T L I N E July 2013Contents
Vice President, Education & Research
Welcome to the third edition of Outline, Redington’s quarterly collection of
thought-pieces designed to help institutional investors make smarter and more
The next ten pages feature articles on the key topics and opportunities we
think institutional investors should be considering as they aim to meet their
goals, including a big picture overview of the pensions crisis, the effect of caps
and floors on hedging inflation risk, our thoughts on investment grade credit
and trend following strategies, and some options for even more unconventional
We hope you find the articles interesting and helpful as you consider how best
to manage the risk-adjusted return of your portfolios.
For more information on any the topics, please do get in touch.
2O U T L I N E July 2013Introduction
Pensions is one of the five global
challenges we all face; it’s up to
us to solve it.
The first challenge facing the planet is global
security. We are spending trillions of dollars trying to
keep the bad guys at bay. Vast resources and effort
are being deployed to keep ourselves safe.
The second challenge is how to live sustainably;
in other words, how to minimise and control the
world’s ever-growing carbon footprint.
Third, we face a global health epidemic. The four
non-communicable diseases – Alzheimer’s, cancer,
coronary heart disease and diabetes – are bearing
down upon us like a steam train. And the tunnel
remains pretty dark.
Fourth, is the economy. Since 2008 and the global
financial crisis, it has been obvious that the global
economic eco-system is fragile and highly unstable.
Anti-government protests in Brazil and Turkey are a
stark reminder that this thing isn’t over.
And finally, the fifth global challenge: inadequate
retirement resources – a.k.a. the pensions crisis.
We’re living much longer than our parents and
grandparents. Some 40 per cent of girls born today
will live to be 100 years of age. And, by 2060, the
UK expects to have half a million centenarians. But
we’re also contracting chronic illnesses in old age,
and the cost of being elderly is high and climbing.
In London you can expect to pay around £1,700 a
week for full-time care for a parent with advanced
Alzheimer’s. For the foreseeable future, the
government is unlikely to be in a position to provide
more than a bare minimum of assistance.
After all, it is spending vast amounts trying to
safeguard its citizens at home and abroad, keep a
badly damaged economy afloat, and maintain the
basic welfare of its citizens.
Unsurprisingly, the nation’s public finances are in a
Time is running out. As Rudyard Kipling inscribed
on his sundial: “It’s later than you think”. Many
pension schemes are following a “Recovery Plan”,
but success is far from assured. The markets have
done them no favours, and the outlook remains
one of continued pessimism. Some recovery plans
are founded on assumptions that are beginning to
Underfunded pension plans are a global scourge:
witness the bankruptcy of the City of Detroit.
Detroit’s pension shortfall accounts for about $3.5
billion of the $18 billion in debts that led the city
to file for Chapter 9 last week. A New York Times
article quotes William Shine, a retired police
sergeant: “Does Detroit have a problem?” he asks.
“Absolutely. Did I create it? I don’t think so. They
made me some promises and I made them some
promises. I kept my promises. They’re not going to
keep theirs.” Not every pension plan faces a Detroit
style challenge, but every pension plan does need a
strategy to become fully funded.
So, what does that look like in practice? Are there
particular assets to be avoided and others to be
cautiously embraced? How do you measure risk
and return? What is the latest thinking on asset
allocation and manager selection? To what extent
should the liabilities drive the asset strategy?
In such matters, it is no longer sufficient to rely
exclusively on the pension plan’s investment
consultant. In today’s super-demanding and hostile
investment environment, it is important for every
trustee and CIO to form opinions and views. In
my experience as an investment adviser, pension
schemes that have prospered during the last
decade, have mainly been those at which every
member of the board has contributed meaningfully
to this critical area: investment strategy.
The 5 Global Challenges
Founder & Co-CEO
3O U T L I N E July 2013Overview
VUCA – The Acronym Of Our Time
For those managing personal or
institutional money, the world is
becoming more volatile, uncertain,
complex and ambiguous.
The globalisation of the world economy, combined
with the acceleration of technology, means stock,
bond and currency markets are more volatile
than ever. The 2008 Global Financial Crisis
has been followed by bouts of volatility on the
back of economic or political bad news like the
developments in Greece and Europe and question
marks like QE tapering in the US.
And the world is more uncertain, too, as a result
of rapidly evolving geopolitical systems, rules and
regulations that impact the countries we live in,
the companies we work for and the markets we
invest in. The challenges we face are increasingly
complex; the products and services we need to help
us solve them are increasing in complexity too.
The result of this triumvirate of volatility, uncertainty
and complexity is overwhelming ambiguity: the root
of the quiet desire to bury one’s head in the sand
and hope for better, easier times. Like the old days.
These characteristics occur in so many areas of
life, and so great are the effects of this concoction
of four that the US military even gave it an
acronym: VUCA. For us in pensions and finance,
VUCA in 2013 refers to:
Volatility - equity, bond and currency market
volatility; the lack of stability and predictability.
Uncertainty - the potential change in the
inflation index calculation; the potential switch to
“smoothing” for pension funds calculating their
recovery plan; the lack of ability to foresee what
major changes might come.
Complexity - in understanding these financial
markets in the era of the “new normal”. The
proliferation and increasing complexity of new
financial instruments and regulation to deal with
increasingly complex markets, moving in ways
experts have never seen before.
Ambiguity - the resulting feeling. Is this the great
rotation from bonds to equities? Or will bond yields
stay low for longer? What is the best course of
The volatility, uncertainty, complexity, and
ambiguity inherent in today’s financial world is
the new normal. And it is profoundly changing
not only how organizations do business, but
how leaders lead and how pension funds are
managed. The skills and abilities of leaders once
necessary to thrive are no longer sufficient or even
Today, more strategic, complex, critical-thinking
skills are required of business leaders to counter
the effects of VUCA. In fact, what’s needed
in pensions is a counter-VUCA: the Vision to
imagine and design a long-term strategy that
repairs the deficit; one that pulls all stakeholders
together and unifies their goal and effort. Then
the Understanding of all the options available
to pension funds to reach those goals; through
education, hard work and diligence, a level
of comfort and understanding about complex
financial products must be reached in order to
capture the opportunities that lead to success.
Third, let’s target Clarity in goals, constraints and
accountability by using SMART principles in goal
setting. And finally, pension funds must, if they
are to reach their goals, achieve a level of Agility
– speed and efficiency in decision-making; not
Together, these four characteristics design a better
future for pension schemes, their deficits, and
their members’ security.
Founder & Co-CEO
4O U T L I N E July 2013Overview
LDI: Hedge Your Bets
When playing roulette and
putting everything on Red, the
odds of winning to losing are not
50:50. It is, in fact, 47:53. The
odds are always ever so slightly
tilted against the gambler.
Similarly, if we imagine playing pension liabilities
roulette with interest rates, it is not as simple as
winning when interest rates go up and losing when
interest rates go down. What happens when rates
stay flat, right where they are?
Typically, the present value of a pension fund’s
liabilities is estimated based on the current yield
curve and consequently the implied forward
rates (red line). Currently, the yield curve is steep
implying that the forward rates are higher than the
current interest rates (black line), as shown
in Chart 1.
This means that current yields need to move up
as projected by the forward rates, just for the
liability value to stay constant. In other words,
should these higher forward rates not materialise
but simply stay constant, the liability value will rise
(assuming other factors remain constant), because
discounting happens at a lower rate than expected.
Redington’s research has found that the simple
situation in which interest rates stay constant
translates to an approximate annual increase of
2.5% in pension fund liabilities one year from
Chart 2 shows what happened in 2012 – short and
medium term rates failed to rise as much in 2013
(red line) as was priced in the forward curve in
2012 (dotted red line).
With little or no hedging, the expected deterioration
of a pension fund’s funding position should rates
remain at current levels is what we refer to as the
rolldown effect. Roll this up over the ten years
or so of the fund’s recovery plan, and this is the
pensions equivalent of trying to run up a downward
escalator; sweating your assets just to stay in the
same place. Now if we factor in market volatility,
imagine there’s a guy at the top of the escalator
throwing rocks at you.
Similarly, when a pension fund is interest rate
hedged, the hedge in place would earn the 2.5%
carry on the rolldown of the yield curve. A partial
hedge would at least lower the incline of the
upward climb to full funding.
An interesting term called “Financial repression”
has emerged recently to describe the current
environment with some compelling reasons as to
why rates might stay lower for longer. However, as
sure as one can be that rates *will* go up again
in the future, as John Maynard Keynes once so
succinctly put it, “the market can stay irrational
longer than you can stay solvent”.
Associate, Investment Consulting
Chart 1: 2013 Spot v Forward Rates Chart 2: 2012 Spot and Forward Rates v 2013 Actual
STEP 5O U T L I N E July 2013
Source: Bloomberg, Redington Source: Bloomberg, Redington
Mind the Cap (and Floor)
Protecting members’ benefits
from inflation leads to added
complexity for pension schemes,
even with the RPI-CPI debate
closed (for now).
UK Pension funds and inflation
UK defined-benefit pension funds tend to have
liabilities linked to inflation, due to the contractual
revaluation of benefit payments for active and
deferred members each year, and the annual
increases granted on pensions in payment.
Historically this risk exposure to (rising) inflation,
and inflation expectations, was one of the largest
risks facing pension funds, which has over time led
pension funds more and more to consider investing
in assets linked to inflation in order to best hedge
Enter the inflation caps and floors
When a pension fund starts to build a hedge for its
liabilities it quickly discovers a subtle but important
feature of its liabilities - while inflation itself can
(and has) been negative from one year to the next,
in a lot of cases the pension benefits that are paid
out cannot decrease from one year to the next.
In the language of the capital markets, the benefits
contain inflation floors at 0%. Most also contain
caps at 3% or 5%.
Why caps and floors complicate the hedging
The presence of the caps and floors changes
the behaviour of the true market valuation of the
liabilities, compared to a situation where they are
not present. The theories relating to option pricing
help us understand how, but the key outcome is
that the change in value of the liability will not be
quite “one-for-one” with changes in inflation, but
somewhat less than one.
As a pension fund begins to build an inflation
hedge from scratch, this level of detail is not
paramount – the most important thing is acquiring
more inflation hedging assets.
As the hedge becomes larger, and begins to
approach (in percentage terms) the scheme’s
funding ratio, it becomes important to take this
effect into account. Typically pension schemes
have three alternatives:
(1) Invest in instruments which exactly match the
behaviour of the inflation floors (“LPI” swaps)
(2) Only invest in “pure” inflation-linked instruments
and accept the mismatch between that and the
(3) Only invest in “pure” inflation-linked
instruments, and attempt to match the behaviour
of the caps and floors – this is often the most
popular approach, but requires careful modelling
of inflation caps and floors, and hence inflation
While the cost of instruments that precisely match
the liabilities has fallen recently, there remains a
substantial difference between the implied volatility
of the inflation floors, and the realised volatility
of the expected inflation rate which schemes
can continue to benefit from by using a dynamic
hedging approach to the inflation risk in their
Director, ALM & Investment Strategy
Chart 1: The
linked assets, and
subject to annual
caps and floors, is
not one-for-one –
but a clear pattern
Chart 2: The
of the 0% inflation
floor continues to
in excess of the
realised volatility of
the inflation rate
STEP 6O U T L I N E July 2013
Don’t Discount the
Effect of Discounting
STEP 7O U T L I N E July 2013
Vice President, Manager Research
Changes to the swap discounting
methodology have created an
additional risk for many pension
schemes, thankfully there is a way
to understand and mitigate it.
There is a new market standard for discounting
swaps. Pre-financial crisis, all interest rate swaps
were projected and discounted using a LIBOR curve
(the reference rate for swap fixings). Following the
crisis, market participants realised LIBOR did not
truly reflect a risk-free rate.
The significant jump in LIBOR versus Overnight
Index Swap (OIS) rates in 2007-8 (see chart) was
due to fears over the creditworthiness of banks.
Market participants realised that LIBOR was not an
appropriate rate to discount a daily collateralised
swap. Since the mark-to-market movements
resulting from changes in swap rates are effectively
a fully collateralised loan, LIBOR was never the
correct rate to use – swaps are dealt on a ‘secured’
basis while LIBOR reflects ‘unsecured’ bank funding
rates. So the market sought a discount rate which
more accurately reflected the economics and
risks of a swap, ie. its collateralised nature which
mitigates credit risk.
The new methodology to discount swaps, under a
clean Credit Support Annexe (CSA) which permits
cash and gilts to be posted as collateral, is to use
an OIS curve. This discount rate needs to reflect
the collateral terms in the CSA, so a swap that
is collateralised daily under a cash and gilts CSA
should be discounted on a sterling OIS curve.
Why does it matter?
Clients who are discounting their liabilities using a
LIBOR swap curve want the swaps they buy (their
hedge) to match the sensitivity of the liabilities.
Under the old methodology, swaps and liabilities
both referenced LIBOR so the value of each moved
in tandem. The new methodology projects swaps
using LIBOR but discounts them using OIS curves.
Since liabilities do not reference OIS at all, there
is a new basis risk which comes into play, ie. the
difference between movements in LIBOR and OIS
rates. As the chart shows, this LIBOR-OIS spread
has been extremely volatile in times of bank
How to mitigate this risk
There are a number of things that can be done.
Firstly, the scheme has to decide what the risk
is and just how significant it is. LIBOR-OIS only
becomes a problem when there is a large mark-to-
market on the existing swaps. Mark-to-market can
be reduced by regular re-couponing of the swap,
but there is a cost to this.
The risk to the scheme is that if there is another
blowout in the LIBOR-OIS spread due to renewed
bank funding pressures, the swap’s value will
not move in line with changes in the value of
liabilities. This would create a divergence between
the value of the hedging asset and the liabilities
being hedged. As the chart shows, both 2007/8
and late 2011 contained periods where LIBOR
was rising (due to an
increase in banks’
credit risk) while OIS
rates fell (as market
priced in rate cuts and
priced out rates hikes
this occur in the future,
of pension scheme
liabilities and hedging
assets could diverge.
Source: Bloomberg, Redington
Investment Grade Credit,
Or Is It?
The tightening of liquid credit
spreads means they are no
longer attractive against many
schemes’ required return to full
funding, however, other attractive
credit opportunities do still exist.
The chart shows how spreads have tightened across
the liquid credit universe, which has particularly
affected higher credit beta instruments.
The hunt for yield in a QE world has led to institutional
investors globally chasing the same assets,
particularly where the securities offer contractual
cashflows with underlying security in case of default.
Many assets which seemed to offer “excess” returns
have rallied to levels which now discount an awful lot
of good news. Examples include investment grade
credit, loans, high yield and asset-backed securities.
These assets provided handsome returns in 2012,
as did most asset classes. Ordinarily, this would have
improved all schemes’ funding ratios but the grind
lower in real yields meant underhedged schemes
saw little improvement in their financial health.
Looking forward, the combination of lower expected
returns from liquid credit and worsening funding
levels means that the return required to reach full
funding by a given date will have risen for all but
the best-funded of schemes. Effectively, this makes
liquid credit unsuitable for many schemes.
Alternatives to Liquid Credit
For clients looking at suitable credit opportunities,
there remain a number of alternatives:
1. Rely on more alpha generation by taking
the shackles off your active credit manager
2. Move down the credit spectrum by taking
more credit risk
3. Seek increased illiquidity premia by investing
in illiquid credit assets
Alpha generation (1) may be suitable but it is
important not to have unrealistic expectations
of the returns achievable. The recent
upheaval across all markets makes us wary
of recommending more credit risk (2) as the
economic climate remains uncertain. Both are
viable options but should be assessed against
each scheme’s requirements.
Illiquid credit assets (3) certainly offer an
attractive alternative. They allow investors to
lock in returns at more attractive credit spreads,
as well as benefit from illiquidity premia which
are more than equal to any anticipated alpha
generation. The greater certainty of cashflows,
often linked to inflation, and a claim on assets
in case of default mean institutional investors are
taking a closer look at this asset class.
Banks have been the natural home of illiquid
assets until the financial crisis.
For pension schemes with
a long-term investment
horizon, it is vital to be
cognisant of the liquidity
requirements to pay
members’ benefits as they
come due. Before embarking
on an illiquid credit
allocation, a framework for
calculating and spending
your illiquidity budget may
well make all the difference.
Director, Head of Manager Research
STEP 8O U T L I N E July 2013
Source: Bloomberg, Redington, Credit Suisse
Chart 1: Evolution of Credit Spreads 2004-2013
Trend-following strategies’ ability
to provide attractive risk-adjusted
returns in a systematic way with
meaningful diversification benefits
can make them an attractive
candidate for pension schemes.
Trend-following strategies (a subset of the “CTA” or
Managed Futures universe) aim to capture the return
premium associated with buying or selling assets that
are demonstrating a particular price trend, either up
or down. These funds are active in the most liquid
global markets – equities, bonds, currencies and
commodities – and seek to exploit the tendency of
markets to trend. As simple as this approach sounds,
there are established behavioural reasons why trends
exist and why they are likely continue to do so.
Assessing the opportunity
Over long periods, trend-following strategies have
achieved strong performance whilst exhibiting low
to negative long-term correlation to traditional asset
classes and alternative investment strategies (see
table) although correlations can vary over shorter time
periods. They have also shown evidence of tail risk
protection; strong performance in 2008 demonstrated
some of their diversification benefits within portfolios.
More recently, returns for these strategies have
generally been milder due to the risk-on/risk-off nature
of markets, although equities and other risk assets
have gained over this period, highlighting again the
A key focus for most trend-following managers is
downside risk control. Many strategies use various
techniques to control risk, with volatility targeting
being fairly common - a typical volatility target is
10% but anything from 6% to 25% is feasible.
Setting Trends By Following Them
Director, Investment Consulting
STEP 9O U T L I N E July 2013
Source: Bloomberg, Redington
Trend-following managers use a wide variety of
technical signals to guide their trading decisions, with
many also using fundamental and non-price data.
Compared with a global equity index, over long time
periods these strategies have displayed significantly
higher excess returns for lower volatility levels and
thus better risk-adjusted returns along with more
favourable “worst year-on-year” drawdowns.
The majority of managers share four traits:
1. Decisions primarily based on technical analysis;
2. Seek to profit from trends in markets;
3. Highly diversified portfolios;
4. Mostly or fully use systematic investment
Managers mostly use futures to implement the
strategies as futures are very liquid, highly regulated
with low transaction costs and they use clearing
houses which mitigates counterparty risk.
Although fees have been considered high for this
type of strategy, we are seeing greater availability of
managers at much more competitive fees including,
more recently, funds without the performance fees
usually associated with them.
Like other return-seeking strategies, they do carry
risks – how to preserve capital when markets fail to
show exploitable trends, and how to minimise losses
associated with the ending of trends? To address this,
it is important to put in place a robust framework to
monitor and mitigate risks.
Saving Mean From
Associate, ALM Investment Strategy
STEP 10O U T L I N E July 2013
Let’s open with a question - what
is the mean excess return earned
by US equities (over short-term
interest rates) since 1870?
The simple answer is to take the average,
which is 5.4%- this is the arithmetic mean (AM).
The trouble is, that’s not what you’d have earned.
An investment that returned 5.4% excess every
year would have earned 7.5 times as much as the
equities over the period. The equities earned the
same as an investment that returned the much
lower 3.9%- this is the geometric mean (GM).
Clearly, which you use makes a big difference.
What do they mean? The AM of some data points
is the sum of all of them divided by the number
of them; in context, it is the average of the
different returns earned every year. The GM of n
data points is the nth root of the product of those
values; in context, it is the total return earned over
the period, expressed as a constant annual rate.
Given n years’ returns r1, r2, ..., rn, then:
To illustrate the difference, suppose a fund
doubles in value every year for three years, then
goes bankrupt. The returns are then 100%,
100%, 100%, -100%. The two mean return
No matter what you earned before, if the fund
goes bust the GM will be -100%; it is simply
a reflection of what you earned over the whole
period, whereas the arithmetic mean reflects
what happens in between.
Now, consider the following 4 scenarios,
with 2 years of returns:
Two things become apparent: firstly, the GM is
lower than the AM; it can be proved that the GM
will always be lower, unless the returns for every
year are the same. Secondly, the larger the moves
are, the bigger the difference. This leads us to
the natural insight that the higher the volatility of
returns, the greater the difference between the
AM and the GM. In fact, one commonly used
approximation 1 is
So, for equities with a volatility of around 20%,
an AM assumption of 5% is roughly the same
as a GM estimate of just 3% (in our example, the
volatility was 17.5%, which leads to an accurate
GM estimate of 3.9%). As might be guessed, this
is one of the biggest causes of difference between
quoted estimates of the equity risk premium;
without knowing which mean is estimated,
the figure is arguably of very little value.
Ultimately, any long-term investor should be
more concerned with GM returns, since they
are what the asset will actually earn. Either way
though, whichever you choose, anyone who uses
an expected return assumption should be very
clear about exactly what they mean.
1 Although other approximations are also used- such as.
See “On the Relationship between Arithmetic and Geometric
Returns”, Mindlin, 2011
The last five years have been
difficult for pension funds,
and the next five are set to be
unpredictable too. The right
reporting tools, combined with
SMART goals, can meet industry
challenges head on.
Mountains of the Mind is a report on the pensions
industry’s greatest challenges, based on the
results of a Redington survey carried out this year.
Decision-makers on pension fund boards gave their
responses in a number of categories, revealing the
items highest on the agendas of those shaping the
future of the industry. In the next five to ten years,
the greatest challenges they believe they face are:
1. Managing the ‘End Game‘
All pension funds face an end-date and an ultimate
goal. Managing progress towards those goals is the
greatest challenge on pension fund agendas.
2. Governance and decision making
A long-time challenge for pension funds is in
implementing ideas and making timely decisions.
3. Deficit funding and management
Stakeholders must not only find the balance
between investment risk and return but also
understand a changing landscape of investment
4. Investment returns
In an environment of low interest rates pension
schemes face the challenge of attaining adequate
investment returns to consistently pay future
Economic conditions have been hard. Pension
funds must navigate their way through events like
the Eurozone Crisis and Quantitative Easing.
Clear objectives, coupled with regular monitoring,
can help meet these challenges.
In Managing the End game, regular monitoring of
scheme performance against long term objectives
lets stakeholders act in an agile way, without
needing to “take views” on market conditions.
Good governance and effective decision-making
can be achieved by establishing clear goals,
progress towards which is regularly monitored by
the board through effective reporting. A set of goals
plus a clear idea of a decision’s impact renders
decision-making a much simpler affair.
Deficit funding and management, the third greatest
risk pension funds perceive that they face, is only
solved by using the right ingredients for an effective
investment strategy. Many investment solutions are
available to overcome this challenge, the choice
of which is bespoke to schemes; however, it’s only
with regular and precise monitoring that schemes
are able to grasp the benefit of opportunities on
their path towards their goals, and make decisions
quickly enough to capture them. Similarly, the
challenge of investment returns is only overcome
by stakeholders who monitor their required returns
to reach full funding so they can take advantage of
investment opportunities as and when they arise.
Lastly, the challenge of the Economy is faced by
checking regularly the vulnerability of the scheme
to significant market moves, like those of the
Eurozone crisis, by simulating ‘what if’ scenarios
and assessing their potential impact on assets and
Unsurprisingly, pension funds that agree clear
objectives, and couple them with objective based
monitoring, create clarity and accountability, and
post better results.
Vice President, Investment Consulting
Challenges Head On
STEP 11O U T L I N E July 2013
A new governor is in town and
there’s talk he is bringing new
monetary tools. What’s facing
him and what might be in his
The new Bank of England Governor has arrived.
Mark Carney’s first meeting of the MPC left a fairly
clear message – markets were pricing in rate hikes
far too soon. Interest rates fell across the whole
curve, giving back some of the gains following
the Fed’s over-hyped taper talk (the US is looking
at slowing down the amount of purchases, not
stopping or reversing them just yet).
Market reaction to the surprise UK and US central
bank statements were significant, highlighting the
fragility that still underlies the rise in both equity
and bond markets in recent years – talk of stimulus
and both markets rally, talk of taking stimulus away
and they both sink.
Is the economy on the road to recovery?
Positive signs for the UK include renewed
expansion in manufacturing, house prices
displaying a recovery, current rates being supportive
of growth and borrowing.
There are also some headwinds, such as renewed
austerity policies, negative real wage growth,
political and economic issues in Europe and
the Middle East, Chinese slowdown fears and
current rates reducing the profit margin on lending
Trying to predict what’s going to happen
is a near impossible thing. There are just too
many variables from both home and abroad.
The economy may turnaround, so long as
rates do not rise too far too fast.
Expanding the unconventional toolkit
If current monetary tools are unable to revive
growth, the new governor might well consider the
- Forward guidance: it seems likely this will begin
in August, with the ECB also looking to follow the
Fed’s lead in providing guidance
- Reduction in base rate: 6.25% reduction in the
base rate since 2007 has helped but not cured
the economy, still, there’s 0.50% left
- Negative deposit rate: If printing new money
did not work existing cash piles could be put to
use by charging those leaving cash on deposit,
encouraging cash holders to invest and not
- Overt Monetary Finance: QE but on a permanent
basis, for example, by sending principal as well
as interest receipts to Treasury
- Widen scope of QE assets: Extend purchases
from gilts to corporate bonds or asset-backed
securities, potentially even equities
- Cancel the debt: If all else fails the BoE could
cancel the amount owed to them by Treasury,
with QE money left with banks.
Implication for pension funds
The economy is far from out of the woods.
Policymakers may have taken their foot off the
monetary stimulus accelerator but it still too early
to apply the brakes. Mean reversion in rates is
not a sensible strategy to rely on to repair funding
deficits. Deflationary threats still lurk despite the
continued above-target inflation prints. Unless
growth turns around soon, the biggest danger is
that we move from a low yield to no yield world.
Vice President, Education Research
STEP 12O U T L I N E July 2013