Views from the LDI desk: Spring 2024 markets commentary

Implications for LDI clients

2024 has so far proved to be another volatile year for interest rates. The market-implied probability of rate cuts has been reduced dramatically in the past few weeks as inflation has continued to come in higher than expected, with the Core Consumer Price Index (CPI) print coming in at 3.8% Year-over-Year (YoY) for March.¹ Inflation expectations have come down significantly, but are still well above the Federal Reserve’s (Fed’s) 2% Core Personal Consumption Expenditures (PCE) target. The market has now priced out rate cuts to 43bps for 2024, which means fewer than two expected cuts forecasted by year-end.²

At the May Federal Open Market Committee (FOMC) meeting, the Fed announced to maintain the current policy rate, but kept the door open to potential future rate cuts and dismissed the likelihood of rate hikes from here, citing an already sufficiently restrictive monetary policy. As of April month-end, the 10yr Treasury had risen 81bps since the start of the year.³ As a result, this has benefited many corporate pensions as the value of their liability has fallen. At the same time, risk markets have done relatively well, improving funded status for clients with a growth allocation.

Despite a volatile year for interest rates, credit spreads have remained relatively subdued in 2024, with the Bloomberg Long Corporate Index tightening just 7bps to 104bps as of the end of April.⁴ In the same period, equity markets rallied 8.61% in Q1, before falling 3.5% in April.⁵ Typical correlations would see higher equity markets at the same time as tightening credit spreads, but credit spreads are now historically low and the potential to tighten significantly further may be diminished from here.

What does this mean for LDI strategies? Although it is important to be aware of short-term yield moves, we encourage clients to take a more strategic view for their hedge. Given how far rates have risen in a short period of time, as cuts have been priced out, this may be an opportune time for clients to re-evaluate their overall interest rate hedge.

The relatively low corporate credit spread now offered in the market may impact the credit spread hedge that LDI clients wish to employ, especially where a choice must be made between allocating capital to either an increased rate hedge or increased credit hedge. A further extension of this, could be looking for value and diversification in diversifying spread assets, as outlined here.

Another important consideration for LDI clients is the shape of the yield curve. The curve remains very flat and inverted at points, which means that key-rate duration exposure is especially important. Since Q4 2022, when we called out the dramatic inversion of the 5s30s curve⁶ here, we’ve seen some steepening, as anticipated, likely hurting some pension plans that are over-hedged at the long-end. The impact of a re-steepening on pension plans is likely to depend on if a normalization of the curve is driven by the front-end, or the long end. In either scenarios, a more precise key-rate duration match will benefit clients that employ an LDI program as outlined here.

Looking out to 2025, the market still has five cuts priced by the end of 2025.⁷ All global developed markets are pricing cuts into 2025, with the exception of the Bank of Japan. It remains to be seen whether markets have appropriately priced rates markets, but if rates do eventually start to fall, corporate pension plans will want their strategic hedge to keep up with potential liability growth.