Author: Adam Phillips
Breene Murphy, Director of Client Experience, recently sat down with Adam Phillips, CFA, CFP®, Director of Portfolio Strategy, to discuss what investors need to know about rising interest rates and what impact this could have on client portfolios. Below are the key takeaways from their discussion. If you have further questions, please do not hesitate to contact your Financial Advisor.
Breene: The yield on the 10-year Treasury bond recently hit 3%, marking the highest level in more than four years. What is behind this increase?
Adam: There are a number of forces creating upward pressure on bond yields. For instance, it is widely known that the Federal Reserve remains committed to raising short-term interest rates. Their reasons for doing this are two-fold. First, the Fed is anxious to normalize interest rates so they have room to loosen monetary policy (i.e. lower rates) when the next economic downturn occurs. Second, higher rates will help keep inflation levels contained as we move further along in the economic cycle.
Expectations are for inflation to trend higher while the economy continues to strengthen, as conditions such as the tight labor market puts upward pressure on wages. More recently, inflation forecasts have increased with the rebound in energy prices and the decline in the U.S. dollar, the latter of which could lead to higher import prices.
Yields are also being impacted by supply and demand dynamics within the U.S. government. For instance, after issuing a record $488 billion of government bonds in the first quarter, the U.S. Treasury could sell an additional $1 trillion in 2018 as it seeks to finance recent fiscal stimulus and manage the widening budget deficit. At the same time, the government has lost a key source of recent demand, the Federal Reserve, which recently began winding down its bond portfolio after seeing the size of its balance sheet swell to $4.5 trillion in the years following the Great Recession.
However, I would note that rising long-term rates also reflect favorable expectations of economic growth. After all, if investors were concerned about a slowdown, we would likely see long-term bond yields decline (prices rise) as investors sought additional safety.
Breene: What role do interest rates play on the economy and investments?
Adam: Higher interest rates are a double-edged sword. On the one hand, there are many who have anxiously awaited a return to more normal interest rates, such as retirees and other income-oriented investors. This group will no doubt welcome higher interest rates on bonds, after being forced to seek income across more risky asset classes such as dividend-paying stocks.
On the other hand, interest rates can also influence economic activity by impacting demand for household and business loans. For instance, if mortgage rates (which closely track the 10-year Treasury bond) continue to climb, there is a risk that a decline in loan volume could lead to lower home prices and ultimately a reduction in homebuilding. However, with most mortgage rates still well below 5%, it appears we have time before this becomes a concern.
Breene: How significant is a 10-Year Treasury yield of 3%?
Adam: As is generally the case with investing, it is helpful to take the long-term view. The 10-year Treasury yield has averaged just 2.6% over the last ten years, so it would seem 3% has become a key psychological level because investors like to fixate on round numbers (see Chart #1). In reality, yields remain well below what is considered normal, if one compares the current environment to the 50-year period prior to the Financial Crisis which saw an average yield of 6.8%. Therefore, we would argue rates have more room to rise before they present a risk to the economy.
We expect rates to continue moving higher off of their historical lows. However, after rising nearly 60 basis points in the first four months of the year, we expect the pace of future moves to slow in the coming months even if the overall trend is higher. A more orderly move higher will likely be easier for the market and economy to digest.
Breene: There has been much discussion recently about the risks of an inverted yield curve. What is a yield curve and why should investors care about it inverting?
Adam: A yield curve is simply the graphical display of bond yields across different lengths of maturities. In a normal environment, investors earn higher yields as the length of the bond maturity increases to compensate them for different types of risk over a given holding period. This positive relationship between time and yield results in an upward-sloping curve on the graph.
In some cases, the yield investors receive on short-term debt is greater than what can be earned by investing in long-term bonds. This condition results in a downward-sloping curve, referred to as an inverted yield curve. An inverted yield curve is noteworthy because such an environment has historically been a harbinger of an economic recession.
Breene: Are you concerned about the yield curve inverting?
Adam: An inverted yield curve would be a worrisome signal. However, it is important to stress that the yield curve is currently flattening, not inverting. In other words, yields across different maturities are converging but an investor still receives a higher yield by purchasing long-term bonds.
The difference, or spread, between the yield of a 10-year and 2-year Treasury is still positive at around 50 basis points (see Chart #2). This suggests we still have room before seeing an inverted yield curve. In addition, I would add that an inverted yield curve does not suggest a recession is imminent. In fact, an inverted yield curve has historically preceded an economic recession by more than one year.
Breene: How is EP’s Investment Committee positioning client portfolios to protect against rising interest rates?
Adam: I think it is important to first note that our Investment Committee has been prepared for rising rates for some time, so recent developments do not come as a major surprise.
Our strategy for managing portfolios in a rising rate environment begins with our broad asset allocation, where we remain underweight fixed income relative to our long-term target weightings across portfolios. Meanwhile, we are focusing on diversification by utilizing alternative investments, which seek to behave independently of the broader stock and bond market.
An effective way to reduce interest rate risk in bond portfolios is to minimize exposure to longer-term bonds. For this reason, our fixed income allocations exhibit a bias towards short-term, fixed-rate bonds. In addition, we continue to utilize floating rate investments that are designed to adjust coupon rates higher as benchmark interest rates move higher.
Within our equity portfolios, we maintain reduced exposure to dividend-paying sectors such as Real Estate and Utilities. This is based on the expectation that, as rates move higher, investors who had been using these areas as proxies for income will rotate back into bonds that offer comparable yields but less risk. Meanwhile, the Financials sector remains among our most favored groups, as higher interest rates generally provide banks with a more profitable lending environment.
Breene: Is there anything else you want investors to know about rising rates?
Adam: As rates continue to move higher, it will be important for investors to remember that yields are simply moving back towards levels that are considered normal. In addition, although higher rates do pose some risks to economic growth, they are just one variable to consider when measuring the health of the economy. For now, the majority of economic data remains favorable and suggests the second longest expansion in history is poised to continue.
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