Institutional investors’ strategic approach to interest rates must evolve to properly reflect the risks and opportunities in today’s markets, according to Michael Cook, vice-president of client relations and liability-driven investment client portfolio manager at CIBC Asset Management, during a session at the Canadian Investment Review’s 2023 Risk Management Conference.
The previous low in interest rates was a significant opportunity to reduce duration, yet few pension plan sponsors were able to adjust their portfolios, largely as a result of the uncertainty around how much interest rate risk they were exposed to, he said, noting the amount of risk investors face can change over time and understanding how to apply range-bound risk models will enable better decision-making in future stressed markets.
“What a range is supposed to do is give you guidance. It’s not going to be a hard line in the sand, but it should be stable over time and it will give guidance as to when you need to take action.”
In order to develop an accurate model, institutional investors need to have a comfortable understanding of the factors that influence interest rates, said Cook, noting using static interest rate shocks is fundamentally flawed. “I think there’s a big opportunity to evolve the approach to risk management around interest rates.”
Any discussion around rates must go hand in hand with the role of high inflation and the ability of the economy to absorb higher rates, he added, noting the Bank of Canada may start cutting interest rates sooner rather than later given how sensitive the economy is to interest rates compared to other developed markets. “We can’t sustain high rates in Canada. Levels have gotten increasingly higher and we’re very sensitive to higher interest rates.”
The bond market is valid in believing the Bank of Canada will target a three per cent interest rate in the long term, said Cook, which will serve as an anchor for long-term bond yields and drive the risk dynamics faced by pension plan sponsors. “There will be times where opportunities are higher than risks. Your interest rate risk is going to change over time. I think, today, we’re facing more potential interest rate risk.”
He agreed 3.5 per cent is the target that long-term rates will struggle to stay above for a sustained period of time. “I’m looking for this number and I also want to know his reasons why. Bank of Canada policy rates are going to have a very hard time staying above three per cent.”
Ultimately, the Bank of Canada is facing a difficult roadmap to cut inflation without breaking the economy, said Cook, noting the risk he worries about most is how much rates could fall if something breaks in the economy. “Pretty soon, they’re going to be faced with the challenge [and] the fastest way to cut inflation and provide relief to consumers is to cut interest rates.”
Read more coverage of the 2023 Risk Management Conference.