Weaponizing an interest rate outlook
Where’s the 10-year U.S. Treasury yield going?
This is the most common question I get from both institutional and adviser clients. It’s a question we’d all like to know the answer to—and one you might expect a bond manager like me to answer. It’s like asking a stock picker where the S&P 500® Index is going to be in six months. The trouble is that these are difficult questions to answer—or at least to answer correctly. Even the most educated prognosticators—the Ph.D. economists—have a rather poor record in predicting 10-year bond movements. Perhaps you trust the collective wisdom of the free markets more than trained economists. You’d find no better record here, either. The market has priced in a rising 10-year rate every single quarter for the last 30 years. But 30 years ago, the 10-year was over 9% versus roughly 2.4% today.1
It would take a great deal of hubris for me, or anyone else, to believe that we can produce great performance simply by virtue of predicting the direction of long-term interest rates. I would never claim to have such a crystal ball. Thankfully, that’s not necessary for translating an outlook into returns in the interest rate market, because investing is different than predicting. With the right capabilities, it is possible to weaponise our macro views to produce better returns via interest rate positioning in a bond portfolio. But it requires two things:
- A broader focus than just predicting a single rate.
- A great deal of discipline in the face of doubt.
When it comes to weaponising interest rate outlooks, investors need to focus on three principles. They need to respect the relative certainty of the outlook at each principal level. Finally, they need to allocate active risk accordingly.
Principal one: Take the long view
First and foremost, investors should remember that long wins in the long run. It’s why bonds exist as an investing asset class to begin with. Over the long-term, investors should be—and generally are—paid to take interest-rate risk. And we believe the more risk they take, the more they get paid over the long run. If you know nothing about the market environment or are highly uncertain about what you think you know, we believe your default position should be to go long on interest-rate risk in your bond portfolios.
Principal two: Understand the current state of the credit cycle
Second, investors should evaluate the current state of the credit cycle within the economy. Ask questions such as:
- How high are debt loads versus history?
- What does the composition of recent lending look like?
- Have riskier loans been easier or harder to get?
- Who’s dictating the terms—borrowers or lenders?
The state of the credit cycle is very important in determining where rates can and will go in the future. Late in the cycle, when debt loads are high and new loans are disproportionately going to riskier borrowers, rates become naturally capped and increasingly more likely to fall than rise. The economy simply can’t handle higher rates without collapse. Or, as usually occurs, rates have already gotten too high and the economy is poised to roll over and take interests with it. The opposite is true when credit is being destroyed: Defaults occur and companies and individuals pay down debt, opening up more runway for a healthy rise in interest rates early in the renewed market cycle.
Principal three: Watch the Fed.
Lastly, investors should ask one pointed question: Where do you expect the U.S. Federal Reserve (the Fed) to go with interest rates over the next 6-12 months, versus what the market is pricing? The Fed funds rate gets a lot of press, but it’s the longer parts of the U.S. Treasury yield curve that matters most for bond returns. Still, when market expectations for the Fed change, more often than not those changes reverberate out over the yield curve into longer-term rates as well.
Weaponising rates in the real world
Let’s say the market is pricing in a rate cut later in the year, but your view is contrarian and you expect the next move by the Fed to be to hike rates. Assuming you were highly confident, that could be a case for taking a shorter interest-rate position. On the flipside, if you believe the cycle has truly rolled over and the Fed will be willing to act quickly to stimulate the economy, then perhaps rate expectations aren’t dovish enough and a longer position is the right place to be on this short-term tactical horizon.
Unfortunately, neither pinpointing the economy’s exact location within the credit cycle nor forecasting the Fed is an exact science. Like history, credit cycles may not repeat exactly, but they often do rhyme, allowing for some predictability. The Fed’s reaction function is reasonably well known, but it is known by everyone. Investors can only have an advantage on this front by staying ahead of other market participants in their forecasting—or by working with a firm that stays ahead on their behalf.
It’s certainly reasonable for an investor to have a view on these fronts and use that view to express a longer or shorter interest rate position, but it’s important to be realistic about your market forecasting skill. No one bats a thousand in this business, and tactical positioning should be scaled according to conviction.
We believe investors should remember that first-and-foremost principal of taking the long view. There should be an awfully high threshold for going against that principal. Remember to take the proper dose of humility when tweaking positioning around the margins to fully weaponise your total market outlook into a final position. As hard as it may be for those that lived through double digit mortgage rates, we believe going long on interest rates is and should be your default position, even when the 10-year Treasury sits at 2.4%.
Hey, at least our rates aren’t negative... yet.
1 As of May 16, 2019. Source: https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield