Why have discount rates fallen?  As Treasury rates fell more than 1% back in March, credit spreads (the difference between Treasury yields and corporate bond yields) rose by more than the Treasury rates fell (see chart below).

These offsetting movements kept discount rates flat and in some cases moved them slightly higher.  As 2020 progressed, Treasury rates began to rise, but this rise was more than offset by credit spreads that began to tighten.  Stimulus from the Fed and improving economic outlook along with the need for yield have been the primary drivers of this spread compression.

Credit Spreads. Source: Bloomberg Barclays

The shape of the Treasury yield curve suggests multiple years of 0% Fed Funds rates with a relatively slow ramp up when the Fed does begin to raise rates. Credit spreads indicate an anticipation of continued Fed stimulus for investment grade companies and a full-scale recovery from the pandemic (i.e., fewer bankruptcies than would otherwise occur). However, there are scenarios that could derail the market expectations such as inflation rising faster than anticipated or the Fed signaling a pullback of economic support – both of which would increase rates faster than expected.

The Fed and inflation

With the anticipated growth from businesses reopening and jobs coming back, along with the additional stimulus from the Fed and the government (current and future), the markets will begin to focus on interest rates.  The key question will be, "When will the Fed raise interest rates?"  The Fed Chairman, Jerome Powell, has said that the Fed will keep short rates low for a number of years to support the economy.  However, the market may start pricing in a move in interest rates ahead of any Fed action. We have seen a bit of this already reflected in the steepening of the yield curve since the successful vaccines were announced.

The Fed's dual mandate of controlling inflation and keeping unemployment low will definitely be tested as the economy ramps up. However, the timing for the economy to reopen is still a big unknown and looks like it will take months, if not longer, before everything is fully operational.  Vaccine distribution and effectiveness will be key drivers of the timeframe for fully reopening.

As we've said previously, what happens with permanent vs. temporary job losses will also be telling as to how the overall global economy rebounds.  Given this, and the Fed's current stance on the Fed Funds rate, we believe that short-term rates will remain anchored throughout 2021, but long rates may move higher as economic activity improves and additional stimulus is made available.

Anticipated inflation will also be a key driver of longer-term interest rates. The Fed has said that it will tolerate a fair bit of inflation before increasing rates. While this may allow long rates to rise a bit, we believe that these rates will move into new ranges, somewhat higher than the ranges we discussed last year with the 10-Year and 30-Year Treasury rates moving into ranges of 1.0% – 1.5% and 2.0% – 3.0%, respectively.

What kind of rollercoaster is this? Update

With all the forces at play in the current economic environment, it's difficult to see how pension discount rates move back to 2018 and 2019 levels in 2021 on a sustainable basis. However, what we may see is a temporary inflation scare driving the back end of the yield curve higher as reopenings and supply shortages drive prices a bit higher along with the possibility for fiscal stimulus given the outcome of the elections.

However, longer term forces, such as demographics and technology improvements, should limit sustained increases in inflation and interest rates over time. This could ultimately lead to 2021 being a great year for pension funding levels, even though the improvements in rates may be fleeting.

The shutdowns have put substantial pressure on the ability to service debt and it will be telling to see how many highly leveraged companies survive over the next year. Credit defaults and the ability to borrow will be key drivers of credit spreads.  A prolonged pandemic, or even a double dip recession (more likely outside the US), will put additional pressure on credit spreads.  Our view is that spreads will continue to shrink as economic activity improves, but only to a limited degree. This is largely due to the expected light at the end of the tunnel for the pandemic and the expectation that companies that have made it this far will ultimately survive.

For institutional investors with interest rate sensitive liabilities, we expect some movement in discount rates with the improvement in economic activity, but not back to sustained levels of 3.5% – 4.0% from a few years back. Conditions may be ripe to see a temporary spike in rates, but other forces will most likely push them back down.

Michael Clark is a Managing Director and Consulting Actuary in River and Mercantile's Denver office and is the Immediate Past President of the Conference of Consulting Actuaries.

Phil Gorgone is a Managing Director and Head of Investments in River and Mercantile's Boston office.