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When the Fed Limbo Party Runs Too Long
Jason D. Edinger, CFA
Of all the difficult things that we as investment professionals are asked to do, predicting the movement and direction of interest rates may be the hardest. The process itself is notoriously inaccurate, and many smart economists and investors have been made to look foolish as a result of bold claims regarding interest rate movements that never materialized or were just patently wrong. It seems that whenever a consensus has been reached regarding the direction and magnitude of rate movements, rates stagnate or move in the exact opposite direction that was forecasted. Like a professional baseball player stepping into the batter’s box and hoping to reach first base safely, interest rate forecasters tend to fail far more frequently than they succeed.
Despite these inherent challenges, economic pundits insist on making daring interest rate predictions year in and year out. These forecasts are made using a variety of techniques and rely heavily on both the current state of the economy and historical data for guidance. Complicating matters is the fact that investors and economists come from different schools of thought (Neoclassical, Keynesian, Ricardian, etc.) and they diverge substantially in their views on how the economic world works and their interpretations of history. Nevertheless, most forecasters tend to use econometrics (a quantitative economic statistical technique) as the baseline for their predictions and blend in additional “soft” data such as investor psychology, behavioral biases, market sentiment, and the unpredictable behavior of the U.S. Federal Reserve.
It is, without a doubt, this last factor which has brought interest rate forecasts to the front of investor’s collective minds over the last several years. Indeed, even more than equity market valuations, GDP figures, or unemployment numbers, interest rate discussions have dominated economic headlines of late all thanks to a U.S. Fed that has enacted unprecedented levels of monetary easing. This policy stemmed from the fallout caused by the Global Financial Crisis (GFC) of 2008-2009, during which the survival of the entire modern economic system in the U.S. was hanging in the balance. Volatility, panic, and herd behavior characterized financial and mortgage markets during those dark days.
In order to provide much needed stability and prevent an even bigger collapse, the Fed began implementing a number of unconventional monetary policy tools, the most lasting of which today is its zero interest rate policy (ZIRP). Technically, ZIRP is a tool available to central banks as a means of stimulating economic growth and activity while holding interest rates close to zero. This does not necessarily mean interest rates must be zero or stay at zero indefinitely, but just that they are close to zero. There are many consequences of ZIRP and they take the form of both risks and benefits. Theoretical benefits include an increase in overall economic activity as the lower cost of borrowing results in increased business capital expenditures as well as personal consumption and household spending. Low interest rates can also help the employment rate, as businesses with new projects and profitable investment opportunities will hire additional workers to meet staffing needs.
Unfortunately, there are also quite a few risks to a sustained ZIRP. One of the most often cited downsides is that it unfairly punishes savers. It is easy to see how. Before the GFC, savers could earn as much as 5.5-6% in deposit accounts at banks of all sizes and geographies – not an insubstantial rate of return for what amounted to a nearly risk-free investment. Today? Banks continue to hold most savings and checking rates well below 1%. Certificates of deposit (CDs) are not much higher, with some of the “best” rates nationwide hovering in the 1.25-1.35% range. Clearly, savers have been forced to turn to the capital markets if they wish to earn any real return on their cash. By definition, they must also assume increased risk. Additional drawbacks of ZIRP include the rising of asset price bubbles, increased leverage in the system, and the promotion of wealth inequality amongst the population.
With the Fed having presided over nearly eight years of ZIRP, the most relevant question on the minds of investors today is: when will the Fed finally begin to raise interest rates and thereby normalize the entire rate environment? Well, the short answer is that they have already done so. For the first time in nearly a decade, the Fed in December 2015 raised its key interest rate – the Federal Funds Rate – by 25 basis points from a range of 0.0 – 0.25% to a range of 0.25 – 0.50%. This hike was based on the premise that the U.S. economy had finished the long healing process and no longer required the continued support of ZIRP in order to resume strong growth. The move was initially viewed favorably by markets, and the Fed followed up the raise with a forecast of four additional rate hikes in 2016, tempering their language with key words and phrases such as “patient,” “gradual,” and “low for some time.”
Investors, however, were not as convinced, as evidenced by the futures market reflecting only two or three hikes in 2016. The widely held belief was that the Fed would make its next move during the April 2016 meeting, after allowing the markets to digest and react to the December 2015 raise. Surveying the economic landscape today, we see that the Fed has failed again to put its money where its mouth is. Last month, the central bank decided against raising its key rate, citing a slowdown in economic activity and a moderation of household spending. Although this decision was telegraphed by Chair Janet Yellen’s speech the month prior, it still brought about confusion and uncertainty regarding the true health of the American economy and what exactly the Fed will do in its upcoming June meeting.
And so we find ourselves at an impasse. On the one hand, we see economic data which supports a recovery and expansion of the U.S. economy – albeit at a historically slow pace – which in our minds would encourage a normalization of interest rates. On the other hand, we have a Fed that is increasingly finding ways to delay such a normalization, moving even beyond domestic issues to consider unprecedented international matters such as Chinese growth and the strength or weakness of the U.S. dollar. Throughout this confusing period, we have often been asked how we can position the fixed income allocation within our model and client portfolios for a rising interest rate environment.
The answer to that question can be tricky and deserves a great deal of analysis. Within our bond mix, we do not rely on interest rate exposure to be the predominant driver of returns. Rather than be limited to pure interest rate risk in the form of higher allocations to U.S. treasury bonds or similar investments, we prefer to allocate to flexible managers that can avail themselves of the full accessible toolkit, including credit, currency, and other niche allocations. With that being said, we do fully realize that interest rate risk (as measured by duration) is of the utmost importance, especially as rates have relatively little room to move lower and significantly more room to climb higher. When they finally do, managers with relatively longer duration will realize a much more significant decline in the prices of their bonds as opposed to managers with shorter duration (all else equal, the longer the duration, the higher the sensitivity to interest rate changes).
Recently we have spent a great deal of time analyzing RINET model portfolios to determine just how exposed they are to the potential of rising interest rates. The answer, in short, is not very. We continue to favor flexible mandates, the so-called “unconstrained funds” that can tactically shift portfolio exposure up and down the entirety of the interest rate curve. These managers can also invest in spaces that traditional, core bond managers avoid or heavily underemphasize, such as high yield, asset backed securities, and credit relative value strategies. For the last several years, these managers have been positioning their portfolios to protect against – and even benefit from – an eventual increase in interest rates. Although rising interest rates will inevitably lead to losses across the entirety of the fixed income landscape, our stable of tactical, flexible, unconstrained managers should provide a cushion and allow our portfolios to sidestep interest rate risk to some degree.
A look further under the hood illustrates this point nicely. In our typical bond mix, the weighted average effective duration (which takes bond callability and other provisions into account) of our portfolio is about 2.6. That is, for a 1% increase in interest rates, we would expect the net asset value (NAV) of our bond group to decrease by 2.6%. The same relationship holds if interest rates were to decrease by 1%, which is highly unlikely and almost mathematically impossible at this time. By comparison, the Bank of America Merrill Lynch Global Broad Market Index has an effective duration of 6.7, nearly triple that of our guideline portfolio. Therefore, the index inherently carries much more interest rate risk and is much more susceptible to rate movements along all segments of the curve.
Given the strength and resiliency that the economy has shown, a labor market which is essentially at full employment, and early signs of increased inflation, we view the likelihood of further rate decreases as minimal. In our minds, it is far more likely that the Fed will be forced to raise rates at least once in 2016, and we view the low path currently embedded in the futures markets as unduly pessimistic. To support its dual mandate of moderate inflation and full employment, we see the Fed having no choice but to raise interest rates if underlying economic data continue to strengthen.
Therefore, we have strategically positioned RINET guideline portfolios across all asset classes to withstand such an increase. Our long-only equity managers should continue to thrive in an expanding economy, and a restoration of earnings growth is not out of the question if the underlying fundamentals continue to improve. Our fixed income book as described above has been strategically positioned for several years to not only hold up but also to benefit from an overall rising rate environment. And finally, our hedged and commodity allocations will not likely suffer serious damage in the event of rising rates. Our hedged managers are generally rate-agnostic and it is likely that the commodity markets have already priced in future hikes. As a result, we remain confident that client portfolios are positioned to provide attractive risk-adjusted returns in all economic and interest rate environments. If the next economic regime includes rising interest rates, we will rest assured that our portfolios are well positioned to deal with such an eventuality, and they will not be caught on the wrong side of the move.