Chief Investment Strategist
Market uncertainty has risen in recent months over potential reductions in the Federal Reserves (the Fed) quantitative easing program a change that could be described as quantitative squeezing. This process will likely first involve a reduction in the pace of buying U.S. Treasury and mortgage backed securities well before potential changes in interest rate policy are implemented. Global central bank policy has become, along with political developments, a key driver of investment returns and thus merits significant investor focus. Given the experimental nature of current global central bank policy, market volatility has increased highlighted by the jump in Japanese government bond yields over the last month, along with the 12% retracement in Japanese equities in the last nine days. While this policy experimentation has been underway, there has been some progress in the real economy, including a reduction in forecasted U.S. deficits. Since we are in uncharted territory with current global central bank policy, and the Fed in particular is evolving its communication strategy, we would expect volatility to continue as investors assess the prospects for quantitative squeezing. However, the Feds guidance about the outlook for quantitative easing remains highly conditional and they could even choose to increase the rate of purchases if conditions warrant. As such, our outlook for moderate global growth and continuing disinflationary trends leads us to conclude that tapering will not be a major negative surprise to the markets and that an actual increase in the federal funds lending rate remains unlikely before 2015.
EXHIBIT 1: THE FED WILL REMAIN THE MAJORITY BUYER OF NEW TREASURIES
Source: Northern Trust, Bloomberg, JP Morgan, Royal Bank of Scotland. Note: Net total issuance = Gross issuance of Treasury bill and coupon paying securities less maturing Treasury bill and coupon paying securities; Net coupon issuance = Gross issuance of coupon paying securities less maturing coupon securities.
The market is currently assessing the impact of a potential reduction in Fed purchases on Treasury yields. Some observers have opined that the falling deficits will mean that the Fed can taper purchases without affecting rates, but we think that is too simplistic. In Exhibit 1, we show the relative proportion of new Treasury issuance purchased by the Fed, along with the total issuance. Total issuance includes Treasury Bills (maturities of one year and less) and coupon securities (Treasury Notes, Bonds and Inflation Protected Securities, with maturities from two to 30 years). The Fed purchased approximately $45 billion of the $100 billion average net issuance for the three months ending April 2013. Importantly, because the Fed does not purchase Treasury bills, this $45 billion purchase equates to nearly 75% of net coupon issuance. Taking a longer term perspective, over the past 12 months the Fed has purchased approximately 53% of net total issuance, or 66% of net coupon issuance.
With the deficit in the United States shrinking from $1.1 trillion in 2012 to an estimated $642 billion in 2013, the Treasury will issue less debt. However, the decrease in debt issuance will likely be limited to Treasury bills. Our analysis in Exhibit 1 shows that even with the reduced overall issuance in 2013, the Fed is still expected to buy the majority of coupon issuance (at current purchase rates). The Congressional Budget Office expects the deficit to decrease further to $560 billion in 2014, but we expect coupon debt issuance will remain steady. While coupon issuance could be reduced further, we think it is unlikely because the deficit is set to accelerate starting in 2016 and there is little incentive to cut issuance as demand is so strong. The conclusion of our analysis is that a reduction of Fed Treasury purchases will increase the supply that will need to be bought by other market participants and it wont be offset by falling issuance.
EXHIBIT 2: PLENTY OF LEEWAY FOR EASE
Source: Northern Trust, Bloomberg.
While the magnitude of the effect of Fed Treasury purchases on the level of interest rates is of some academic debate, Federal Reserve Chairman Ben Bernanke made clear his views in a speech on March 1, 2013 at the Federal Reserve Bank of San Francisco. In this talk, Chairman Bernanke cited a growing body of research indicating that large scale asset purchase programs (LSAPs) are effective at reducing long-term interest rates. He also cited the global nature of the major fixed income markets and the high correlation in interest rates partially due to the similarity in monetary policy being followed. While we dont believe Chairman Bernanke has found the crystal ball for interest rates, we think these views will guide the Feds policy action and indicate that the Fed will be cautious in reducing their purchases as they will worry about upside pressure on rates. We think this is illustrated by recent comments from Fed officials about their option to both increase and decrease the levels of Treasury purchases over time, depending on economic conditions.
In December 2012 the Federal Open Market Committee (FOMC) announced that it decided to keep the target range for the federal funds rate at 0 to 1/4% and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6.5%, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committees 2% longer-run goal, and longer-term inflation expectations continue to be well anchored. As highlighted in the left panel of Exhibit 2, both inflation and inflation expectations, as measured by the Personal Consumption Expenditure Price Index and the 10-year breakeven rate, respectively, remain below the 2.5% threshold. Further, inflation has been trending downward as falling commodity prices, continued deleveraging and marginal wage growth have suppressed prices. April 2013s 0.7% year-over-year inflation stated rate was the smallest increase since October 2009 in the midst of the financial crisis. While the unemployment rate has dropped substantially since its peak, it has been distorted by the labor force participation rate, which fell from a pre-crisis level of 66.0% to 63.3% in April 2013. While the participation rate is naturally declining because of the aging population, half of the decrease may be attributed to short-term business cycle dynamics. As shown in the right panel of Exhibit 2, a cyclically adjusted participation rate of 64.6% results in an adjusted unemployment rate of 9.3%. We think this illustrates the poor quality of the improvement in the labor markets so far, which should continue to support easy Fed policy.
We now turn to the question of the effect of rising interest rates on stocks. In Exhibit 3, we look at the historical relationship between six-month equity returns and rising 10-year bond yields.
EXHIBIT 3: RATE INCREASES FROM LOW LEVELS NOT A STOCK PROBLEM
Source: Northern Trust, Bloomberg. Data is from 1/31/1961 through 4/30/2013.
A positive correlation indicates that both interest rates and equities increased, while a negative correlation means that interest rates increased but equities declined. As Exhibit 3 illustrates, rising interest rates do not necessarily auger negative equity returns. In fact, when the 10-year yield is below 5%, the correlation between the interest rate movements and equity returns is consistently positive, averaging 0.37. The 5% threshold remains intact even when we only consider six-month periods where the 10-year yield has increased 50 basis points or greater. For the 14 observations wherein this occurred, the correlation averaged 0.52. We think stocks act this way because investors initially welcome increasing interest rates from very low levels, viewing it as a sign of fundamental economic improvement. It is only when rates start to become much higher (say over 5%) that investors begin to worry that the economy will slow and that corporate profits may be at risk.
To analyze how a spike in interest rates impacts bond prices and eventual returns, we provide some simplified scenarios looking at both the economic and accounting or statement basis. In all of these scenarios, we assume that bond yields spike from 2% to 4% at the beginning of Year 1. The scenarios shown in Exhibit 4, which use a $1,000 par-value bond, include:
EXHIBIT 4: WHAT BOND CATASTROPHE?
Source: Northern Trust.
Starting with the Buy & Hold Scenario, the rate spike to 4% from 2% causes the $1,000 bond to depreciate in value by $73 resulting in a Year 1 total return loss of $53. At face value, this looks like a loss; however, assuming the borrower is credit worthy, the investor will get all of this back by maturity. The bond needs to re-price due to the jump in interest rates, so that a new purchaser gets a 4% return (now earned through a combination of income and price appreciation). Forgetting about the mark-to-market aspect and only focusing on cash flows (the top line in Scenario 1), the investor will get $20 a year and then, at maturity, the investor will get the principal back, and this amounts to a 2% average return. In other words, the investor gets what they signed up for a 2% yield-to-maturity. Unfortunately for the investor, however, the market is now providing 4%. As such, the only true cost is the opportunity cost; the investor has a 2% bond but could have had a 4% bond by waiting for the spike.
The investor who patiently waits for the interest rate spike is depicted in the Perfect Foresight scenario. Here, the investor waited in cash for a year (yielding 0%) and then got a 4% return for the last four years. The only downside in this scenario is the 0% first-year return, which lowered the overall return. What if the interest rate spike never happened? Investors who have been sitting in cash over the past few years waiting for this interest rate spike (that has yet to occur) know the cost of this strategy well.
The Forced Liquidation scenario is one in which investors may find they get less than they expected. Recall that in this scenario our investor signed onto a deal for a 2% yield-to-maturity meaning a 2% average annual return over the life of the bond. But that requires that the bond actually be held to maturity. In Scenario 3, the investor is forced to sell the bond at the end of Year 3, while the bond is still using the principal element as a way to provide a secondary market purchaser the market interest rate of 4%. As such, the bond is still trading below par and the seller will take a hit on the principal. In this case the average return is only 0.7%.
In the High Coupon Bond scenario, although our bond takes a hit in the first year due to the interest rate spike, it still trades at a premium given the 6% coupon it carries. In numerical terms, the bond came into the year priced at $1,189 and falls to $1,073 at the end of Year 1 (still above its original, and eventual end, value of $1,000). The bond will continue to slowly fall in value as the falling principal level offsets the $60 coupon payments to provide a yield closer to the going 4% rate. Of course, the investor can sell the bond for a gain in the years leading up to maturity, but doing so means giving up the 6% coupon. The accounting return of 2.2% is significantly below the cash flow return of 6% as the price of the bond returns to $1,000. Had we shown the years leading up to what is displayed in the exhibit, we would have seen returns well above the 6% original yield-to-maturity as investors pushed up the price of the bond, coveting the 6% coupon return in the midst of falling yields.
While we have demonstrated that the risk to fixed income investing through rising rates can be mitigated through proper portfolio construction, investors are still interested in exploring alternatives to fixed income. In this low-rate environment, fixed incomes historical utility of income generation is diminished, and its liquidity function and diversification benefits have risen to the forefront. As shown in Exhibit 5, the expected 5-year annual return from a broad U.S. bond portfolio is expected to be just 2%, well below the roughly 9% enjoyed over the last 35 years. With correlations across many assets classes converging during the 2008 financial crisis, there is a premium on diversification away from assets overly exposed to equity risk. Investment-grade fixed income is uniquely positioned to fulfill this mission. But for investors who are significantly overweight fixed income, primarily due to its lower volatility, hedge funds stand out as a potential option.
EXHIBIT 5: WHERE IS THERE LOW VOLATILITY BEYOND BONDS?
Source: Northern Trust Capital Market Assumptions, Bloomberg. U.S. Aggregate historical is based on data from 12/30/1977 through 12/31/2012. Hedge Funds represent the Hedge Fund Research Institute Composite Index.
How can hedge funds generate such low volatility? What is their return potential? And, what are the drawbacks? The low volatility is attributable to lower exposures to risk factors (such as equity risk) and can be further reduced through diversification among funds and across strategies in a fund-of-fund structure (a primary way to access the hedge fund asset class). Also, hedge funds can provide some diversification for a broader portfolio while potentially providing higher returns than those out of investment-grade bonds given the low rate environment. During the period of Federal Fund rate hikes from late 2003 through November 2005, the Fund of Funds Index outperformed the U.S. Aggregate handily (appreciating 12.6% vs. 5.9%). During the August 1993 to July 1995 jump in the federal funds rate, the outperformance was more modest at 9.2% compared to 8.3% for the bond index.
From a future return standpoint, we believe our expectations for hedge funds reflect a realistic view of their historical performance and future alpha generating (returns beyond what the broad markets offer) capabilities and here it should be noted that hedge funds generally have a high fee hurdle that needs to be overcome through alpha generation. Hedge funds can be less tax efficient vehicles than traditional long-only stock or bond options, so a focus on taxability and the specific investment vehicle utilizing hedge funds is important. While the diversification benefits are higher than many other asset classes, we still consider this a risk asset because in a significant market downturn hedge funds are unlikely to offset equity market risk. For example, during the bear market of 2007 to 2009, the S&P 500 Index fell 50% and the Fund of Funds Index declined 20% with a correlation of 0.62. In the subsequent recovery, the S&P 500 Index has climbed 137% while the Fund of Funds Index has climbed 21% with a correlation of 0.78.
A final issue for discussion is liquidity. Hedge funds are not fully liquid instruments, and this must be considered in determining a proportionate allocation to the investment. This limited liquidity and the higher correlation to equities (especially during stressed environments such as the financial crisis) are the primary reasons that hedge funds are not a substitute for investment-grade bonds. However, we do believe that their reasonable return outlook, low volatility and lower correlations to other risk assets, make them a good candidate for a diversified portfolio. Keys to successful investing in this arena are good manager research (including access to the best managers) and proper portfolio construction. While very large allocations can justify a customized hedge fund program, many investors will be better served in a fund-of-funds program where they can get good research, manager access and portfolio construction.
Market volatility has increased of late as investors have begun to debate the potential for a reduction in the Feds quantitative easing program. We stress that a reduction in the rate of purchases is not tightening, and we dont see the potential for a rising federal funds rate until 2015 at the earliest. The current disinflationary environment gives the Fed plenty of headroom, and the poor quality of improvement in the unemployment rate also argues for rates being lower for longer. We do, however, expect market volatility to remain somewhat elevated as the Fed hones its communication strategy and investors digest incoming economic data. The historical evidence suggests that equities can withstand a rise in rates from todays low levels, as it reflects a normalization of the interest rate environment. We think that investor concerns over a catastrophic environment for fixed income investing are overdone, even with a more bearish interest rate outlook than we are expecting. Finally, for investors looking for low volatility assets in todays low interest rate environment, we think that hedge funds should be considered by those who can accept the liquidity constraints and tax considerations involved.