European pension funds are being forced into hedging long-term interest rate exposure as long-dated forwards hit near-historical lows. The funds are in a catch-22 because regulators are requiring they match long-dated plan payouts--which means locking in low forward rates now. While some regulators, such as the Dutch, are considering allowing funds to wait for more attractive rates, strategists are cautioning the worst is yet to come as one of the most liquid and well-established derivative markets is being dominated by regulatory decisions rather than fundamentals.
In spite of some curve steepening at the end of last week, interest rate forwards have hit near-historical lows and are down about 1% on a year ago, across most of the curve. It's demand driven by regulation, rather than fundamentals, noted a fixed income strategist. A swaps trader explained, while most funds seem to be holding back from receiving longer dates at these levels, the market is continually buzzing with talk of funds being about to enter deals and this is dragging down forwards still further. The strategist said mathematically, the forward levels are reflecting how much demand there is out there.
While the rates swaps market is liquid across most of the curve, European pension funds' requirements to receive longer-dated swaps are on such a large scale that they are dampening the swap yields, particularly out to less-liquid longer-dates. The cycle is being driven by regulatory moves, rather than fundamentals, noted a strategist, who cautioned while the present looks bleak for funds about to hedge, it is only going to get worse. "If you are last to do this you will get the worst deal," he added.
The European Central Bank frustrated pension funds still further last week with increasingly hawkish talk driving up speculation of a rate hike in the near term, fuelling the likelihood the euro swaps curve will continue to flatten. "It must be very worrying for [pension funds]," noted a rates analyst. "We have rates going up and at the same time the long end is not going up at all."
