Interest rates have been low for a while, but began to rise in April. Where are the rates headed, and what impact will they have on the financial markets? The answer may depend in part on what the U.S. Federal Reserve (the Fed) does and on investor behavior. Ever since the 2008-2009 financial crisis, many investors have viewed bonds as a “safe haven.” If interest rates continue to rise, this may have some interesting implications.
Prior to a discussion of interest rates and their impact on financial markets, it’s worth considering the longer-term historical perspective of where we are and where we’ve been. As shown in “Long-Term Perspective,” this page, interest rates have fallen steadily for well over 30 years. From the inflation-fueled high interest rates of the early 1980s, the 10-year Treasury has fallen from returns in the mid-teens to low single digits. While we’ve indeed had a recent increase, U.S. government interest rates are still quite close to lows not seen since the start of this data series in 1962—more than 50 years ago. Listening to the popular financial media, one might get the impression that interest rates have had a large increase, yet, when using a longer-term perspective, rates are still very low.
Since the beginning of the financial crisis, the Fed has employed the majority of its resources to stimulate the U.S. economy. The primary strategy, commonly referred to as “quantitative easing” (QE), has involved the Fed purchasing U.S. Treasury and mortgage securities in the open market. This policy began in November 2008, when the Fed announced a program to purchase $600 billion of U.S. agency mortgage-backed securities. Evolving on four separate occasions since then, the Fed is now purchasing $85 billion of Treasury and mortgage securities per month, essentially expanding its balance sheet by over $1 trillion per year. In many ways, similar to financial market behavior during the crisis, the Fed’s monetary policy has broken new historical ground. “Balance Sheet,” p. 61, showing the assets held by the Fed, is indicative of the magnitude of this policy.
By reducing the level of interest rates, in addition to the goal of stimulating the economy by providing cheaper credit, the Fed has a correlated goal to impact investor behavior. In the wake of the 2008 crisis, many investors fled equities and other perceived “risky” assets for the safety of cash and short-term bonds. As interest rates declined and returns on cash fell to near zero, investors began to search investment alternatives for yield. While not yet ready to purchase stocks, investors slowly began to explore moving back out the risk curve.
Recently, as the global economy has continued to inch towards recovery, there’s been a great deal of speculation regarding future Fed policy. When will QE end? And, more importantly, what will be the impact of the Fed’s slowing—now referred to as “tapering”—stopping and potentially reversing its bond-buying program? As investors have begun to anticipate these changes, we’ve witnessed a recent impact on interest rates and the price of bonds—as rates rise, bond prices decline. This fall in bond prices has been felt throughout the fixed income markets, including U.S. government and agency securities, corporate and high-yield, as well as municipal bonds.
As the marketplace has collectively worried about future Fed policy, we’ve seen a fairly abrupt rise in interest rates. One explanation given for this increase is a general anticipation of higher inflation. However, the evidence, at least so far, doesn’t support that inflation is increasing. “Inflation Expectation,” this page, shows the 10-year U.S. Treasury yield (in red), along with the rate of inflation implied by the spread between the 10-year Treasury and the 10-year Treasury Inflation Protection Security (TIPS) (in blue). Interest rates have indeed seen an abrupt increase—the 10-year has jumped nearly
1 percent from its lows. Yet, inflation expectations have actually fallen since the beginning of 2013.
We’ve seen some other indicators pointing to low inflation levels as well. Consumer expectations of inflation, measured by the University of Michigan Survey, have begun to diverge slightly from actual Consumer Price Index levels. Nonetheless, inflation expectations today are similar to levels seen over the prior eight years (see “Nothing to Fear,” p. 62). Markets and investors fear inflation, but we’ve yet to see it emerge from most economic indicators.
Over the long term, financial markets are driven primarily by fundamental factors such as economic growth, inflation and earnings, for example. Yet, over shorter periods, as we saw in 2008 and 2009, markets can be significantly impacted by investor cash flows. While the Fed has been a large purchaser of bonds in the last few years, it turns out that they’ve had a lot of company. Data from the Investment Company Institute shows that mutual fund investors have moved a very large amount of money to bond funds during the last few years. “Where’s the Money?” p. 62, shows that well over $1 trillion has been invested in open-end bond mutual funds since December 2006. The June 2013 data shows a slight reversal in this trend. This shift, however, is currently small, relative to the magnitude of the last 6.5 years, but may be a harbinger of future bond fund flows.
Rising Interest Rates
Over the next few years, the fundamental forces of economic growth and inflation will drive the level of interest rates. However, in the shorter term, as discussed above, it’s quite likely that investor cash flows may impact markets. To some extent, we may have seen this over the last few months, as investors have begun to anticipate future Fed policy and interest rates.
Interest rate moves are tightly linked to bond prices, and the effects are very well understood. Most fixed-income investors have tools that can calculate how bond prices will change with a specific change in interest rates. However, low interest rates have spurred investors to seek yield in a number of other asset classes. To the extent that a rise in interest rates changes this investor behavior, we may see these other assets impacted as well. A few examples are worth noting.
Real estate investment trusts (REITs) have often been viewed by investors as securities with both bond and equity features. While REITs can have exposure to many types of real estate—for example, residential, commercial and retail—in general, they have higher yields than stocks, as well as exposure to economic growth. And, due to the ability to raise rents, REITs often have less inflation risk than the fixed-interest payments of bonds. Given investor demand for lower risk assets with some yield, REITs have performed well—according to Bloomberg, the MSCI REIT index has returned 74.8 percent from December 2009 through June 2013—more than 19 percent above the S&P 500.
Yet, in the last few months, the performance of REITs may be indicative of the impact of interest rates rising. The largest REIT exchange-traded fund is the Vanguard REIT ETF. “Unwelcome Surprise,” p. 63, shows its price performance, as well as the shares outstanding since the beginning of 2013.
As interest rates began their recent rise, the price of the Vanguard REIT ETF began to fall. As this descent commenced, the shares outstanding dropped by over
10 million. While this is only a small percentage of the outstanding shares, the impact in price—similar to the move in interest rates—was abrupt. Over the long term, this will likely be noise. Yet, for investors who purchased this REIT exposure as part of their low risk, income portfolios, this move may have come as an unwelcome surprise.
Emerging Market Bonds
As U.S. interest rates declined, some investors looked to foreign markets for yield. The Fed’s policy hasn’t been unique. Both the European and Japanese central banks have endeavored to keep interest rates low and spur economic growth. However, the local currency debt of emerging market countries has provided a yield premium to developed bonds. The logic to own this asset has also been supported by some economic fundamentals. Generally, the debt to gross domestic product ratios of emerging nations is much lower than those of developed ones. Further, the fundamentals of the specific emerging nations—for example, Mexico, South Africa and Turkey—are generally not correlated to each other.
Yet, here too, we see the impact of investor flows. While the long-term fundamentals may indeed support a portfolio allocation to local currency emerging market bonds, the recent rise in rates has affected this market as well. “Emerging Market Bonds,” this page, shows another exchange-traded fund—the JP Morgan Emerging Market Bond ETF (EMB). While very different from U.S. REITs, this asset shows quite similar recent behavior. From April 2013, as interest rates began to rise, we started to see a slide in the price and then a correlated drop in shares outstanding. Also similar, as the rise in interest rates ended, the price of EMB has begun to recover. Again, long-term fundamentals will drive the price of this asset over time, but investor cash flows can create some significant short-term price volatility. (For more information on emerging markets, see “How to Invest in the Emerging Markets Now,” by Gregory D. Singer, in this issue, p. 56.)
High Dividend Stocks
Another strategy that’s been suggested for prudently earning higher yields has been to own equities that pay relatively larger dividends. Here too, we see some impact of higher interest rates. The S&P 1500 equity index, as of July 23, 2013, contained 968 stocks that pay dividends. In examining this group of dividend-paying stocks, we find that the average 3-month return was 10.8 percent. However, if we look at different segments of this stock index segmented by dividend yield, we see that the higher dividend-yielding stocks have had a lower return. The 200 stocks with the highest dividend yield returned an average of only 4.6 percent. The next 200 highest yielding stocks returned an average of 10.1 percent.
Diversification and Time
Holding a diversified portfolio of assets has become a well-respected technique for reducing overall portfolio risk. Modern portfolio theory is founded on this notion of finding an “optimal mix” of uncorrelated assets to maximize portfolio return “per unit of risk.” This concept lost some credibility in 2008, when markets witnessed a global investor “flight to safety;” nonetheless, the mathematical concept remains true.
The issue is understanding what factors impact asset prices and correlation. Each market environment holds its own unique features, and the key is to recognize them. In most periods, the price of stocks, emerging market currencies and REITs would be unrelated. But, the combination of historically low interest rates, along with a heightened investor demand for a defined yield, has tied these asset prices together. In short, this is essentially a hidden risk that may have surprised investors.
Over time, this short-term market behavior will fade and underlying market fundamentals will reassert themselves as the driver of asset pricing. For investors with an appropriate long-term horizon, the recent price moves will also fade away as noise. However, for those investors who sought higher yields in portfolios supporting short-term goals and objectives, the recent correlated price declines may have indeed been a nasty shock.
The old saying that “there’s no such thing as a free lunch” is nearly always true. Over long periods, diversification reduces portfolio risk. Over shorter periods, however, it will often fail at the worst possible time.
To hear the author discuss investing in a rising interest rate environment, watch his video at http://videos.wealthmanagement.com/video/Andrew-Parker.