Real interest rates are an anchor for the valuation of all assets. The classical theory of interest holds that as a ‘discount rate,’ they embed the market’s relative preference for cash today over cash in the future.
The US cash rate is arguably the best sense we have of a global ‘risk free’ interest rate, and it has been rising. With policy rates and shorter dated Treasuries rising materially over the last two years are global asset markets sitting on a powder keg?
The weird: Yield curve conundrums
One might expect the most direct impact of higher policy and short-dated Treasury rates to be felt on Treasuries of longer maturities. When this doesn’t happen it can be a source of confusion.
However this shouldn’t be a surprise. An FT alphaville article in 2015 highlighted previous phases of flattening in the US in the 80’s, 90’s, and the more famous ‘Greenspan conundrum’ of the mid-2000s.
In spite of this, market commentary again seemed confused last year, most notably when US 10-Year yields were falling as policy rates increased.
As Tristan Hanson wrote in November, this shouldn’t be a surprise, and as I briefly discussed a couple of weeks ago, there are other forces which drive long dated Treasury yields, most notably expectations of policy and inflation over the long term (rather than on a cyclical basis), and the perceived insurance properties that they may offer. Other assets will have even more drivers of valuation given greater uncertainty about the nature of cash flows.
Ultimately however, rates cannot persist indefinitely without other assets being impacted. Most simplistically, we can consider the relationship this way: if we could earn 4% on cash, then why would we want to earn the same on a (normally) more risk corporate bond or stock?
The reason that reactions to rising US rates from other assets have been relatively muted seems to be because the market views them as temporary.
Until very recently it seemed that the market saw 2% as a key level for the Fed Funds rate. Just a month ago, the futures curve was implying that markets believed rates would hit the north of that level in April 2019 and then stay there.
Just a month later, expectations for the time taken to reach 2% have shortened and there are signs that the two percent anchor is being loosened.
There seem to be a couple of reasons for this: the market is sceptical about the sustainability of the growth we are seeing, is (rightly) questioning the traditional rule of thumb that measured growth and policy rates have a tight relationship, and/or is of the view that companies and households do not have room to live with higher rates given levels of indebtedness, the prevalence of ‘zombie’ companies, and so on.
A new face in the Fed
The arguments above seemed to be a fair reflection of consensus until the pivotal moment in the middle of 2016. At that point any sense that rates would rise seemed extremely remote and the biggest risk of policy error was the danger of excessive tightening (the ‘taper tantrum’ was in part a reflection of this).
Views have changed rapidly however, and with a new face in the role of Fed Chair, the greater risk of policy error is now seen as keeping policy too easy for too long. However, spending time picking over the minutiae of Jerome Powell’s own personality and views is likely to represent the highest attention to the wrong detail. As Richard Woolnough at Bond Vigilantes highlighted this week, it is the data that matter. Economies are difficult to control, and little fine-tuning can be done with such a blunt tool as policy rates alone; there are plenty of periods in the past when it has seemed that Central Bankers couldn’t get ahead of the curve if they tried.
Negotiating the environment
As always, we believe that valuation is essential to dealing with uncertain environments like this. If rates stay low, many assets that have done extremely well over the last ten years may not sell off but still offer very unattractive returns (still negative after inflation in a number of cases). If investors begin to consider that rising rates could be more persistent, then this could prompt much volatility and a greater need for selectivity within asset classes.
Assets which are a touch sensitive to bond yields such as ‘defensive’ areas of the equity market like consumer staples, have been beneficiaries of the falling rate environment since the financial crisis. This can be seen as the chart below, which shows the performance of global consumer staples relative to the world equity index (the purple line) and US 10-Year Treasury yields (the red line). The increase in yields since 2016 has weighed on these stocks on a relative basis and in some areas, valuations still leave little margin of safety to cushion against further increases.
Selectivity will also be critical in corporate bonds. At an index level, US corporate bonds (as shown by the BofA Merrill Lynch US Corporate Master Index below) decoupled from Treasury yields in the financial crisis, Eurozone crisis and more recently as commodity prices collapsed. From these more attractive starting points of value the bonds were relatively resilient as Treasury yields increased from 2009 to 2011 and in the tapering phase and its aftermath.
More recently, with spreads at more normal levels, the relationship in yields has been tighter. Richard Woolnough noted that some (most notably Bill Gross) have pointed to the recent technical breakout of ten-year Treasury yields from their technical ranges. Areas of the corporate bond market where spreads offer limited compensation for risk could be vulnerable should this persist.
Fortunately the variety of fixed income assets means that there are a range of tools to deal with these environments. Selectivity will be critical, as will active duration and currency management, and the use of tools like floating rate notes, inflation linkers or ‘kicker’ bonds.
As I wrote this week, the only place where it is easy to generate returns through active management is in the world of hindsight. There are always new challenges and new uncertainties, and a profound shift in interest rate dynamics should it emerge would certainly be amongst them. As we have written repeatedly, a shift from the trends of the last twenty years will impact returns, volatility and correlations in new ways. In these times it will be necessary to have flexibility, and the ability to be highly selective when constructing multi asset portfolios.