The Optimal Interest Rate Scenario, Until Now

When I was running cashflow tests for life insurers, there was one scenario that was among the best for most insurers (life or otherwise).  The optimal scenario was a slow protracted rise in interest rates, say 1/2% per year for 10 years, or flat (no change).  Yes, with the slow rise, there will be unrealized capital losses, most of which will evaporate with time.  But excess cash flows will be invested at higher rates, raising the value of the firm.

I remember talking about this with people in the finance areas of other life insurers, and there was agreement — a slow rise in rates would benefit the industry as a whole.  Maybe annuity floor guaranties played into that as well.

But there are a number of parties that could not bear with the slow persistent rise.  Most governments of the world, including the US would find their budgets severely inverted if interest rates slowly rose and stuck.  As such, governments will do what they can to avoid such a scenario.  They don’t want to end up like Greece. That said, if they do end up there, expect that the governments hand losses off to bondholders, pensioners and/or medical care recipients.  The prime motive of a secular government is to survive, even if core goals are not achieved.

Thus at present, what is optimal for governments is to keep rates low for a long time.  Let savers get clipped, that government programs get paid for.  The risk here is that the bond market rebels and rates rise whether the government likes it or not.  But should that happen, and the government cannot pay on all promises made, it will force losses onto all long-term recipients of cash flows.

Perhaps policy will relax the strain on those in the private sector who have made long-term promises to pay, like pensions.  I would not count on that.  The government will be content with its own survival.

About David Merkel 144 Articles

Affiliation: Finacorp Securities

David J. Merkel, CFA, FSA — From 2003-2007, I was a leading commentator at the excellent investment website RealMoney.com (http://www.RealMoney.com). Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and now I write for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I still contribute to RealMoney, but I have scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After one year of operation, I believe I have achieved that.

In 2008, I became the Chief Economist and Director of Research of Finacorp Securities. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm.

Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life.

I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

Visit: The Aleph Blog

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