The Federal Reserve’s years-long zero-interest rate policy has flattened Treasury yields to where rising interest rates and inflation are almost assured manifestations. Investors may have to face the threat of rising bond yields. Damage to high quality, long-duration debt instruments would likely happen far in advance of a rise in interest rates with periods of significant volatility. What are the risks to portfolios? The first in a series of three papers that examines this questions is now available.
“Houston, We Have Liftoff!”
Since the Great Financial Crisis (GFC) of 2008, investors have accelerated their allocations to fixed income. At the same time, the gravity of the Federal Reserve’s zero interest rate policy has flattened yields in all fixed income sectors, denuding the investment landscape of income.
We are not living inside a bond bubble; instead we are in the thrall of an interest rate “Black Hole.” The question is: Are we nearing the limits of these financial physics, and if so, what will be the damage to portfolios from a rising yield curve and rising rates? What will be the consequences of upending what has been the perceived safety of fixed income?
Investors now more than ever need to understand how the likely trajectory of monetary policy will affect their bond portfolios. We believe a framework that examines the likely evolution of the yield curve in different economic and interest rate scenarios is critical.
The Fed’s Goals
Recall that the Federal Reserve’s great experiment was initiated to achieve three things:
- Negative real yields – to fight deflation, cheapen credit, and reflate financial and real assets.
- Higher discretionary income – to aid in deleveraging and prop up private consumption.
- Cushion the budgetary consequences of fiscal stimulus – while private sector balance sheets were repaired.
I think these goals have largely been met and the need for extraordinary monetary accommodation is diminishing. The Fed’s “Great Monetary Experiment” is poised to enter a new phase in the next year.
Financial assets have reflated, producing a strong wealth effect that has supported upper income consumption.
Real Assets – in particular housing – have also begun to reflate, broadening out the wealth effect to middle income households, which will offset drags this year from higher taxes.
A debate now rages between those who believe Quantitative easing (QE) has largely been economically ineffective, responsible only for financial asset reflation, and those who believe QE will be too effective, igniting an inflationary spiral. We take a balanced view. There are real economic benefits to QE – primarily as “fill dirt” for the hole dug by the collapse and slow recovery in credit demand after the GFC. But as keen observers of credit markets, we see QE’s prolonged extension reincarnating some disturbing trends such as the resurgence of leveraged buyout (LBO) activity, more permissive “covenant-lite” bank loans and leveraged investment strategies.
Damage Before a Rise in Interest Rates
Duration is the sensitivity of the price of a fixed-income investment to a change in interest rates. We believe damage to high-quality, long-duration debt instruments will be experienced far in advance of a rise in interest rates. As economic activity accelerates in the back half of this year, the Treasury curve will respond by steepening. This will occur even as the Fed remains emphatically committed to zero, keeping the “front-end” of the curve firmly anchored. While it may be counterintuitive, we believe that the Fed’s protracted commitment (explicitly targeting 6.5% unemployment and 2.5% inflation) will act as an accelerant to a yield curve steepening.
The realization that the Fed not only expects the curve to steepen but may in fact even encourage it will be a wakeup call to investors. As financial markets grapple with the coming structural change in the yield and interest rate environment, high-quality, fixed-income bonds will likely experience periods of significant volatility. The transition to a new investment paradigm is rarely smooth. To lay out the topic of duration and help investors navigate these likely turbulent waters, click on Life Inside an Interest Rate “Black Hole”, the first in a series of three papers on The Danger of Duration in Investor Portfolios.