Interest rates have been on the rise since late last year as market participants correctly anticipated the Federal Reserve would move forward with interest rate hikes. As I write this, Government Long-Term Treasuries have lost over 16% since last July. Not surprising since bond prices fall as interest rates rise. This is something I have been talking about for the last couple of years. Conservative investors, invested in Bond Fund portfolios are likely to see significant losses in principal if rates continue to move higher.
We must remember that risk is relative. Risk in financial lingo is a statistical measure; standard deviation for stocks and duration for bonds. Studies have shown that people are not necessarily risk averse, but LOSS averse. Studies show we hate losing twice as much as an equal sized gain. This means we accept this “risk” as long as the markets move up. However, when markets move lower, this risk measure is intolerable. For conservative investors with bond portfolios, the risk is in duration. Let me explain. If a bond portfolio has a duration of 10, when interest rates move up by 1%, the bond portfolio will fall around 10%. Duration is a measure of interest rate risk, and with rates likely moving higher, a shorter-duration portfolio or bond latter may be more beneficial.
After the election, we saw the stock markets move up fairly quickly. However, over the last few months, we have seen them begin to move in a range. Ed Yardeni, an economist, gives a great reason for the stagnation in market prices. He said in a recent interview, “After the election, many people started to revise their GDP numbers up, figuring fiscal policy was coming, regarding infrastructure spending and tax cuts. Moreover, I think now we are getting a little dose of reality and realizing it is going to take a while to see all that unfold. Meanwhile, the economy has not changed radically since the election," so "we are not seeing it in the hard data." The markets are always pricing in the future. If we do not see fiscal policy take shape soon, the markets could begin to price in a congressional stalemate similar to what we saw recently with the healthcare bill.
Another indicator to keep an eye on is the yield curve. We have not seen the long-term interest rates rise as much as the short-term. This is called, “flattening of the yield curve.” The credit markets are far larger than the equity markets and often give hints as to market participant expectations. When we see a flattening of the yield curve, it represents one of two things or a combination of both. Either the market does not expect future inflation to meet current expectations, or the market is pricing in slower economic growth. Only time will tell. If interest rates become inverted, which means short-term rates are higher than long-term rates, the markets are pricing in a recession or deflation. Something to keep an eye on.
The start of 2017 has been interesting from a political standpoint, but the markets have so far rewarded the policy change. Keep in mind, what drives the economy is both Monetary Policy and Fiscal Policy. Politicians can only change fiscal policy. At this point, Monetary policy has been pushed to its limits, and it is time for fiscal policy lend a hand.
Brandon H. VanLandingham
Chief Investment Officer