How High Can Interest Rates Go?
Over the years, “How Low Can They Go?” was a question commonly asked by our pension clients from 2008 to 2021. Clearly, times have changed and now the question our clients are asking is “How High Can They Go?”. Long-term US interest rates used to value pension plan liabilities were unlikely to fall below about 2.5% and bottomed out at about that level in mid-2020. With pension discount rates up to over 5% today, the question on many pension plan sponsors’ minds is how much higher they might go?
The Future is Difficult to Tell
Looking at our crystal ball, it is much harder to put a limit on how high pension liability discount rates can rise vs. fall because these rates are both long-term Treasury yields and credit spreads (or risk premia) on corporate bonds. We can have a thesis on Treasury yields, but corporate bond spreads can go very high, very quickly when there is fear of many large companies defaulting.
The best example of this is the Great Financial Crisis (GFC) when spreads on high-quality bonds went from less than 1% to over 6% within a few months. Importantly, the yield on long-term Treasuries is only loosely related to the short-term interest rates set by the Federal Reserve; long-term expectations of GDP growth and inflation are much more important drivers. Classic economic theory states that long-term risk-free bond (i.e. US Treasury) yields should roughly equate to expected nominal GDP growth (real GDP growth plus expected inflation).
We believe that 30-year Treasury yields are unlikely to hit 5.5% (as of this writing, they are currently about 4.25%). And if they were to breach 5.5%, they are unlikely to stay there. Annual real US GDP growth has averaged 2% per year since 2000 and 3% since 1961. Given demographics, US GDP growth is more likely to be around 2% than 3% going forward. Annual inflation has averaged 2.5% since 2000 and about 3.75% since 1961. Again, given demographics and giving the Federal Reserve some credit for being able to keep inflation in check, inflation is more likely to be in the 2-2.5% range than over 3%.
If long term GDP growth is expected to be about 2% and long-term inflation is expected to be about 2.5%, then long-term Treasury yields “should” be about 4.5% for everything to stay in equilibrium. Obviously, the market prices of securities do not sit at a theoretical equilibrium value, but it is good to have a sense of where fair value may be.
For example, during the 2008-2019 period, US 30-year Treasury yields averaged 3.35%. GDP growth averaged about 1.67% and inflation averaged about 1.77% as the after-effects of the GFC proved difficult to shake. Adding these together, you get 3.44%. This means that 30-year yields averaged very close to where they theoretically should have been given how economic growth and inflation turned out (3.35% vs the 3.44% implied by GDP growth + inflation). But 30-year Treasury yields also swung from a high of 4.5% to a low of about 2% during this period, as investors constantly re-evaluated long-term economic prospects. In addition, the Federal Reserve did a lot to try and actively reduce long term bond yields to stimulate the economy.
High Inflation and Real GDP Growth
Following the pandemic, this has helped to push long-term interest rates up as investors rethink the long-term macroeconomic environment. 30-year Treasuries bottomed out at about 1.2% in mid-2020 and have hit 4.3% in recent months. There is a good chance that they can go higher than 4.3% but sustaining levels much above 4.5% would require either meaningfully higher long-term inflation forecasts or higher expected real GDP. Bond yields can certainly diverge meaningfully from fair value for sustained periods, but so long as the underlying economic forces stay stable, then they should be pulled to fair value over time.
Based on our long-term GDP growth estimate of 2% and inflation forecasts of 2-2.5%, we think that 30-year Treasuries should yield somewhere in the range of 4-4.5%. We think 10-year Treasuries should yield about 0.25% less to account for having less duration risk. Pension liability discount rates are sensitive to both 10-year and 30-year yields. If we add 1% for “fair value” credit risk for high quality bonds, then we see pension liabilities yields at 4.75-5.50%, which is about where we are today.
Will rates go even higher?
We don’t think so. It is unlikely that we’ll see the 30-year Treasury yield exceeding 5.5%. Credit spreads on high quality bonds can certainly exceed 1% if markets become concerned about company defaults, but these episodes tend also to be temporary. Periods when credit spreads increase a lot also often correspond to periods when Treasury yields fall as investors seek a safe haven. Thus, the impact on pension discount rates can be muted. All-in, pension liability discount rates are therefore unlikely to sustain levels above 7% except possibly during something like a GFC-level financial crisis when credit spreads are very wide. We see fair value for discount rates in the 4.5-5.5% range depending on the specifics of a pension plan’s liability duration. It is possible to see short term fluctuations and pension plan sponsors will want to be ready to capitalize on those movements to hedge more of their liabilities or off-load them through a pension risk transfer should liability discount rates be above fair value.
Source data provided through Macrotrends and Federal Reserve Economic Data
- Pension discount rates have surged to 4.25% today, but how much higher can they go?
- The unpredictable nature of long-term Treasury yields and credit spreads makes the future hard to decipher.
- Historical analysis points towards equilibrium, but market fluctuations keep stakeholders on their toes.
- Predictions suggest 30-year Treasuries may stabilize between 4-4.5%, impacting pension liability discount rates.
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