Prognosticating the Effect of Higher Interest Rates

People often ask me how I think equity markets, including Master Limited Partnerships (MLPs), will perform when interest rates are rising. It’s a timely question, since bond yields have been moving higher for the past couple of months. The yield on the ten year U.S. treasury recently touched 2.5% as markets look ahead to a tightening by the Fed later this year. Of course, the Fed has been steadily pushing back the first rate hike, since it turns out they’re not any better at forecasting rates than the private sector, as I wrote a couple of months ago in Preparing for Higher Rates. Nonetheless, they will be right eventually and financial advisors would like to be prepared.

The relationship between interest rates and most asset classes is not simple. Bond prices mathematically fall with rising yields since their payouts are fixed, but equity securities whose return comes from both dividends and dividend growth have a more complicated relationship with rates.

Stronger economic activity can be expected to translate into faster profit growth and higher dividends, in which case higher rates represent confirmation of a more robust economy and need not be negative. Conversely, if rates rise while inflation is unchanged, it results in higher real rates (i.e. after inflation) and this in theory reduces the value of all assets.

But we know rates will rise, and the yield curve is pricing in the expectation of a higher Fed Funds rate in the next 6-12 months. So part of the question comes down to what the market will do if the market’s own forecast of the timing of rising rates turns out to be correct. In this respect, it boils down to a question of market psychology; if rates rise following the path already reflected in the yield curve, it ought not to surprise. In fact, the prices of treasury bonds ought not to change, in theory, since their prices already reflect that path. They obviously will move, but where will they, and equity markets, settle?

I have a friend who has an exceptionally acute sense of such things. Through seemingly logical analysis, he often arrives at an insight that sometimes seems so obvious but wasn’t at all clear until he pointed it out. On this topic, he recently noted to me that if he was considering buying stocks but planned to sell upon a Fed rate hike later this year, he wouldn’t invest. It seems so blindingly obvious, but if something unsurprising will happen that would cause you to sell, you would avoid putting yourself in that position.

Therefore, if you put yourself in the mind of this mythical yet rational investor; if this participant isn’t going to sell stocks at that time, who is? And the answer is, people with a short term horizon who expect selling by others and wish to avoid a near-term drop in their portfolios, or hope to buy back shortly afterwards. And from whom exactly will they buy back their shares, if our mythical yet rational investor (perhaps with many like-minded folk) is not then a seller?

This is exactly the kind of set-up that can cause equity markets to reach higher prices than existed prior to the “news”, as the participants expecting to buy from other more hasty investors find far fewer such impulsive folk exist than they might have expected. We don’t forecast equity markets, but don’t be shocked if stocks rally on the first rate hike.

The analysis of market psychology is of course an endless game that never ends. Events big and small are anticipated, happen and are reacted to along with big and small surprises too. As soon as the aftermath of one event reveals the true disposition of willing buyers and sellers through their subsequent actions, the build-up to another event begins. It’s very hard to be good at figuring this out, and in my experience the supply of people with opinions far and away exceeds the number whose views result in profitable outcomes. But I know just a very few who have turned astute observation into market profitability.

For our part, while this type of prognostication can be fascinating, there isn’t a plausible move in interest rates that would cause us to sell investments which are, by definition, held for the long run. Several months at least lie between today and the resolution of that particular event. When it happens, if equity markets fall, we shall be among those whose portfolios suffer a loss in value. However, we shall not be a seller in response to something not surprising. Ben Graham is believed to have said that in the short run the market is a voting machine while in the long run it’s a weighing machine. We’ll weigh things up down the road.

The Problems with Reported Inflation

The CFA’s bi-monthly magazine includes an article on the gradual mis-reporting of inflation that’s taken place over the years (“Double, Double Toil and Trouble”). Criticism of how the government calculates inflation is not new, and I included a chapter on this in my latest book Bonds Are Not Forever. For a start, it’s hard to take seriously an index which assigns a 24% weighting to Owners Equivalent Rent (OER), a wholly unsatisfactory solution to the problem that owned housing represents an investment that happens to provide a service (which is shelter) whereas the CPI seeks to measure the consumption of goods and services (including shelter) but not the return on investments (such as real estate). OER relies on estimates of what owned housing would rent for if rented, a concept with which very few homeowners have any familiarity. It’s just one example of the white-coated statisticians in their inflation laboratory concocting mathematical potions that have no relevance to the outside world.

John Williams runs, and he’s probably one of the better known critics of current practice. One has to acknowledge that the inflation critics are something of a fringe group, and at their most extreme mutter about a widespread conspiracy to cover up the Federal government’s impending bankruptcy. I can’t say I align myself with such extreme views, but nonetheless I do believe that beating inflation as reported is a dangerously low hurdle for an investor to set when planning their retirement.

In the 1990s the calculations were altered to allow for substitution and quality improvements. Both of these can make sense and need not be controversial as long as the user understands what the resulting altered figures mean. Substitution recognizes that the basket of goods and services from whose fluctuating price the CPI is derived changes in real life, and therefore allows that the CPI should reflect these changes. Consumers shift from, say, steak to chicken when relative prices change but also bought fewer vinyl LP records when CDs became available. Clearly, not changing the weights to account for this would mean that the cost of horseshoes would still be a component.

Quality improvements are more subjective in my opinion and rarely seem to include quality deterioration. Commercial flying is a perfect example. When I describe some of the subtleties of calculating inflation in presentations and note that the inflation statistics have incorporated a modest quality improvement in flying in recent years (due to easier cancellation terms) the audience typically laughs at the absurdity of the notion. Longer security lines, poorer food and sometimes surly flight attendants may not resonate with the statisticians who measure such things but are assuredly part of the flying experience for most users of inflation figures.

John Williams gets to the heart of the matter when he argues that in combination, substitution and quality improvements have altered the CPI from measuring the cost of a constant standard of living to the cost of a constant level of satisfaction (constant utility is the economic term). Although the difference may seem trivial don’t be fooled; since living standards generally rise over the time you care more about the cost of maintaining a constant standard relative to your peers and the larger economy. If your lifestyle includes buying the latest ipad you want to maintain that standard, and falling ipad prices (which don’t occur in reality but do occur for inflation statisticians once new model quality improvements are factored in) may give you more utility, but utility isn’t always fungible and you may not have asked for it.

It also occurred to me that in the debates among academicians and government departments about how to calculate inflation, the beneficiaries of the lower inflation camp are invariably well represented. Lower inflation flatters the government’s finances through reduced cost of living adjustments on entitlements as well as tax-bracket creep (since the income bands at which higher tax rates kick in are adjusted up more slowly than they would be otherwise). The tangible and political benefits no doubt invigorate those arguing for a lower-resulting methodology while the benefits to those sincerely advocating a higher-resulting methodology would seem to be far more prosaic.

It’s one more contributing factor to increasing income inequality (since those most exposed to the vicissitudes of inflation calculations rely disproportionately on entitlements and welfare) but it will be no surprise that different inflation calculation methodology has never been much of a hot-button political issue. For investors, you take the world as you find it. Fixed return securities such as bonds provide scant compensation for inflation risk. Someone asked me just the other day what I thought was the best protection against a steady increase in inflation (whether it’s inflation as measured by the government or simply the higher version as experienced). The best answer we have is to invest in equity securities whose underlying businesses possess built-in protection in the form of pricing power. Stable companies with consistently high operating margins; midstream Master Limited Partnerships (MLPs) who often own fee-generating assets whose pricing is inflation linked. These are two of the best forms of defense an investor can adopt. While it’s probably a stretch to assume a government conspiracy, it’s hard to identify participants in the debate whose interest is to err on the side of higher (i.e. more conservative) inflation calculations.

Bonds Are Not Forever Book Review

Laurence B. Siegel, Research Director at the CFA’s Research Foundation, has written a generous, largely positive review. He has evidently read the book quite carefully and has written one of the more extensive reviews I’ve seen. I am flattered by his kind attention.

Investors Are Overweight Bonds

So says the Wall Street Journal in an article this morning announcing that Investors See End To Bond Rally. Of course the real problem with fixed income is not just the eventual tapering of asset purchases by the Fed, maybe sometime next year under Janet Yellen or maybe beyond that. It’s that yields don’t provide any return to compensate even current inflation never mind the possibility of it one day rising.

The WSJ notes that U.S. taxable bond funds currently hold $3.8 trillion. It’s hard to believe but in 2000 the figure was $720 billion, so whether that counts as a bubble or not, it’s certainly looks like a collective overweight to this particular asset class. And the sorry Math of fixed income is that if you hold a ten year treasury security yielding 2.7% and in a year’s time ten year yields have risen to 3.1%, the loss on your holdings will offset the interest income; Total Return = 0. This is a reasonably likely prospect for trillions of dollars of invested capital. After taxes and inflation, it’s a 2-3% loss in purchasing power, around $75-115 billion in losses. The math is similar for shorter maturities where yields are even lower, and owning high grade corporate bonds doesn’t alter the outlook much either. So far bond returns in 2013 are an example of what investors will likely face for many years to come.

Since diversification is good, investors should diversify away from fixed income. When you hear a bond manager say they’re focused on sectors of the market where prospects are better, or that bonds are still an important source of stability, run the other way. You’ll be better off holding more cash than you might otherwise like, since cash has a good chance of beating bonds, and lean on the stability provided by cash to own more equities than you might otherwise. The Fed doesn’t want you in fixed income.

Some Monetary Officials Contemplate Higher Inflation

Saturday’s New York Times ran a thoughtful piece that should send a shudder through any holder of long term bonds. While maintaining low inflation is typically in the DNA of every good central banker, some are starting to question the orthodoxy of a relatively inflexible approach to changes in the price level. While high inflation (10%+) is widely (and no doubt correctly) believed to be highly damaging, there is support for the notion that inflation above 2% (the Fed’s target) can ease price adjustments. This is because while few workers will willingly accept a cut in pay, 5% inflation with a 1% pay hike results in the same 4% loss in REAL earnings as a 2% cut with 2% inflation. In other words, a little bit of inflation allows companies to increase profit margins as long as their revenues keep better pace with inflation than their costs.

Presumptive Fed Chairman Janet Yellen has argued for the benefits of temporarily higher inflation, and many academics including some quoted in the NYTimes article have argued the same. It’s a logical extension of the strategy of financial repression currently being pursued. Interest rates that are equal to or below inflation are a fairly painless way to reduce the inflation-adjusted value of debt, and in the U.S. we have $36 trillion of debt if you add all levels of government, households and students as I showed in my book, Bonds are Not Forever; The Crisis Facing Fixed Income Investors.

It illustrates the shifting winds; because debt is so ubiquitous, minimizing its cost to borrowers is more important than appropriately compensating those who fund it. So far it’s sound public policy. But clearly holders of long term bonds yielding close to current inflation rates are scarcely being compensated for the risk that a drift up to 3-4% inflation may turn out to be a quite acceptable monetary policy outcome.

How To Lose Money On 4-Week Treasury Bills

Here is the first in what may become a series of financial market oddities brought on by the Federal government’s shutdown and the threat of a debt-ceiling related default.

I noted a report that banks were stocking up their ATMs with additional cash in preparation for increased customer demand as we approach the October 17 deadline. Another thing that caught my eye was that T-bill rates have been going UP. In fact, certain T-bills, those presumably most vulnerable to an actual missed payment, have moved quite sharply. Specifically, the October 31 T-bill yield has positively jumped over the past several days, from around 0.02% to 0.13%. It rose 0.05% just today.

Presumably as investors in the safest of safe securities begin to contemplate the unthinkable, they are concluding that October 31 might be a poor choice of maturity. So something quite remarkable has happened. For probably the first time in at least five years, since short term rates plummeted to almost 0% as a result of the financial crisis, it’s possible to lose money on T-bills. For years all they’ve done is get issued at insultingly low yields and remain there. In a different era you could lose money holding T-bills if rates unexpectedly rose, but such has not been part of the landscape for a very long time.

Nonetheless, the investor who bought the October 31 T-bill yesterday at 0.08% and then decided today to become a trader and sell them at 0.13% actually lost money even after the (admittedly paltry) interest income due for holding for one day. A net loss of $35.28 on each $1 million face value held. A beer and a sandwich for two perhaps if all you held was $1 million worth, but there are $89 billion of these outstanding so yesterday’s holders collectively suffered a mark to market loss of $3 million.

I’m sure more oddities will surface courtesy of our leaders in DC.

PIMCO's Low Rate Forecast

Bill Gross’s monthly investment outlook is invariably worth reading, and this month is no exception. His writing is engaging as well as insightful, and as the overseer of $2 trillion in assets he’s worthwhile listening to. It turns out that like me, Bill has re-examined the Fed’s interest rate forecasts following the non-taper last month. He’s acknowledged the extremely gradual normalization of policy rates embedded in that forecast. Quantitative Easing grows the Fed’s balance sheet at $1 trillion a year, and as limitless as their appetite for bonds appears even this largesse must in due course end.

Bill elegantly makes the case for an extended period of low rates and therefore low returns on bonds, and links this to the deleveraging that took place following World War II. It was accompanied by “financial repression”, which is to say that savers received the short end of the stick compared to borrowers. He almost echoes my book, Bonds Are Not Forever, in making this point.

So now the question for the investor is this. In one corner you have the Fed’s $3.5 trillion balance sheet which is still growing. In the other you have Pimco’s $2 trillion collection of bond portfolios. The Fed is a non-commercial buyer unburdened by the need to demonstrate value added. As such they readily buy bonds at yields that are lower than private market demand alone would put them. Pimco has little choice but to hunt around for values in a market with fewer than it might otherwise have. They are in a real sense competing with one another, fighting it out for yield although the Fed has some unfair advantages in this contest.

The Bond King is hardly likely to throw in the towel on an entire asset class at this stage of the game. But for the rest of us, free of the commercial obligation to persist in investing in a market where yields offer scant return and no compensation for risk, we really can dial down our exposure to an asset class widely acknowledged to be expensive. Less bonds, more equities but importantly more cash too. You probably won’t hear Bill Gross make that recommendation, but his letter could just as easily have led to that conclusion.

Why This Government Shutdown Won't Be The Last

As we’re all being reminded, 1996 was the last time the Federal government was forced to shut down, the result of a budgetary dispute between then House Speaker Newt Gingrich and President Bill Clinton. It didn’t last that long, was economically inconsequential and was generally believed to have worse consequences for the Republicans than the Democrats.

Politics has become generally more partisanship since then and at least according to many participants far less collegial. Disputes over the budget have become more frequent in recent years, with the last crisis over raising the debt ceiling in 2011 causing investors to contemplate the unthinkable, that the U.S. might miss a debt payment. The Federal government is currently operating under automatic sequestration, the result at the end of last year of the calculation by both parties that automatic spending cuts were preferable to a negotiated agreement.

In fact much of what the rest of us regard as dysfunction in Washington DC can be traced to the power of incumbency and the reduced turnover of elected officials. The House of Representatives in particular is increasingly unrepresentative of mainstream Americans and more reflective of the more liberal and conservative wings of each party. Gerrymandering, that process by which congressional districts are drawn as if by a blind chimpanzee, are intended to create electoral districts full of like-minded voters. While an original intention was to assure that racial minorities would be represented by one of their own, an unfortunate consequence has been to steadily reduce the number of Congressional seats that turn over. In last year’s election 90% of the House and Senate were re-elected.

While that might sound as if our legislators need not care much about what voters think given their success at retaining their seats, a great many of them are acutely tuned to the elections that really matter; the primaries through which each party selects its candidates to run in the general election. The polarized politics we watch is because of the increasingly powerful role played by primary voters. House seats that will reliably return a Congressman of a certain party are uncompetitive in the general election and therefore the primary of the dominant party becomes ever more consequential. It forces House members of both parties to be ever more sensitive to their party activists or risk being outflanked by an even more extreme candidate that better appeals to the “party faithful”. As a result, the centrist voter is increasingly marginalized. There doesn’t appear to be anything to reverse this trend, at least for now. In fact, if anything there’s some evidence that it’s further exacerbated by internal migration of Americans to districts and states that they perceive to be “red” or “blue”. I write about these developments in my book, Bonds Are Not Forever – The Crisis Facing Fixed Income Investors.

This analysis is intended to be non-partisan. For investors of either party or no party, the future is likely to include more frequent disputes that require one side to blink as the protagonists perform for their hard-core constituency. America’s challenges require compromise, and regrettably we are electing representatives for whom total victory is all that counts. It will become a more familiar landscape.


Blackrock Forecasts Years of Poor Bond Returns

Credit Peter Thiel, Blackrock’s deputy chief investment officer for fundamental fixed income, for providing an honest assessment of the outlook for fixed income. “Overall returns of the market will continue to be negative as monetary policy shifts,” he said. So one of the biggest bond investors in the world has an appropriately cautious outlook on total return. Not that there won’t be good places to invest in the bond market. It is of course a vast place. But we might infer from Thiel’s comments that the less “equity-like”, and more “bond-like” your chosen market, the less satisfactory will be the results. Developed world sovereign debt would be at the bottom of the list of places to look for value, closely followed by agencies and investment grade debt.

At least Blackrock won’t be justifying bond investments based on historic performance, or because the diversification is still useful in spite of the poor return outlook, two explanations we’ve come across from brokerage firms for recommending high grade debt.