By Rusty Vanneman, CLS Investments
The Federal Reserve (Fed) is predicting two more rate hikes in 2017, and that has many investors weighing the potential pros and cons of a rising rate environment. But, there are many reasons to believe interest rates could fall.
The stock market is overvalued, and currently in a mature bull market, so it could easily correct. Uncertainty over fiscal policy in the Trump administration could sink inflation expectations, and the economy could certainly slow. Global rates remain lower than domestic rates, and investor sentiment is so one-sidedly negative right now, it might not take much for rates to start falling.
So, if they do, are your portfolios prepared? Below are six tips to help you be ready for whatever direction rates may go.
1) First, define the terms. What is the definition of an “interest rate environment”? Does it mean short-term rates the government/Fed controls? Does it mean long-term rates that market forces determine? Does it mean Treasury bonds? Corporate bonds?
The bond market is way more complex than overnight rates, 3-month bills, or even 10-year Treasury yields. Like the stock market, the bond market comprises a lot of levers for active managers to pull when making investment decisions, trying to enhance portfolio returns, and managing portfolio risks.
Defining an “interest rate environment” by the Fed’s controlled federal funds rate is arguably the best method (but yes, that’s debatable). In this case, the definition is simple: What move did the Fed make last? The Fed is increasing short-term rates. Thus, by this definition, we are in a “rising rate environment.”
Defining it by longer-term rates is trickier, and it depends on the time frame. Some investors prefer three months, and in that case, 10-year Treasury yields are in a “falling rate environment.” If we look at the 1-year time frame though, rates are rising.
2) Get your rates straight. Short-term rates are rising, but that doesn’t mean all interest rates are moving higher. In fact, since the last fed funds rate increase, 10-year Treasury yields have fallen. Interest rates — depending on maturities, credit risks, and more — can move in different directions.
3) Think about possible market returns in terms of probabilities. That’s how we view longer-term rates at CLS Investments. Asking “What is possible?” and “What is probable?” is far more effective than trying to forecast a single return expectation, which can be a dangerous and unhealthy practice for a few reasons. Thinking in terms of probabilities and possibilities is also consistent with building balanced portfolios.
4) Be optimistic, but mildly. At CLS, our current expectation is the bond market will generate a positive return over the next 12 months. We currently assign that a 60% chance. That compares to the long-term average of 85% for positive 12-month returns since 1926. So, we are less optimistic — but still optimistic — than the long-term averages.
5) Watch the stock market. Investors own bonds for a number of reasons. They may own them for dedicated income streams, or they may own them to pay off future liabilities. But typically, investors own bonds to diversify equity risk. Not only do bonds dampen portfolio volatility over time, creating a smoother ride for investors, they generally have positive returns when the stock market sinks.
Also, equity opportunity drives long-term investors’ portfolio returns — and risks. So, for many asset allocators, how they feel about the overall stock market will drive bond allocations. In other words, own more bonds (regardless of interest rates) when stocks are expensive; own fewer bonds when stocks are on sale.
6) Go against the grain. Investment managers can’t beat their competition if they are doing the same thing everybody else is doing. With this is mind, isn’t it concerning that everybody is talking about a rising rate environment?
There’s an old market chestnut: “The markets like to move in the direction that causes the most pain.” The pain trade is for lower interest rates. Bottom line: It is not a sure thing we are in a rising rate environment, so be prepared for whatever may come.
Rusty Vanneman is the Chief Investment Officer at CLS Investments, a participant in the ETF Strategist Channel.
This information is prepared for general information only. Information contained herein is derived from sources we believe to be reliable, however, we do not represent that this information is complete or accurate and it should not be relied upon as such. All opinions expressed herein are subject to change without notice. 2381-CLS-3/27/2017