interest rates

Change is Still Constant

pyramid

We wrestled for a long time with the issue of how to build portfolios in a zero-interest environment. The crushing of interest rates distorted values in the investment markets. The old ways of thinking carried too much risk, in our opinion. (When interest rates rise, bond prices tend to fall.)

So about a year ago, we settled on the concept of ballast. This enables us to tailor portfolios to address individual preferences. Different clients can have differing portfolios, while retaining common elements that enable efficient management.

Ballast refers to holdings that might be expected to fall and rise more slowly than the overall stock market. Ballast may reduce the volatility of the overall portfolio, thereby making it easier to live with. And it may serve as a source of funds for buying bargains when the market seems to be low. We’ve been able to put this thinking into effect.

A little over a year ago, monetary policy in the U.S. shifted from zero interest to a plan to raise interest rates over time. As we foresaw, this has not been great for bond prices. But now U.S. Treasury securities actually have a little bit of a yield these days, with short term maturities recently reaching over 1% for the first time in years.1

The return of interest rates on lower volatility, short term, liquid balances makes it easier to hold cash and cash substitutes as part of a portfolio structure. As interest rates continue to normalize, returns on cash could increase.

We like the portfolio framework, shown above, that we developed a year ago. We will continue to assess clients that may be suitable for this strategy. As the economic environment changes, we will review the need to adjust the tactics used in each layer of the portfolio. Change is still constant.

We will update you soon on the trends we are seeing in our long term core investments. Clients, if you would like to talk about this or anything else, please email us or call.

1Effective Federal Funds Rate. Federal Reserve Economic Data, Federal Reserve Bank of St. Louis. Accessed March 2018.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

All investing involves risk including loss of principal. No strategy assures success or protects against loss.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

Tactical allocation may involve more frequent buying and selling of assets and will tend to generate higher transaction cost. Investors should consider the tax consequences of moving positions more frequently.

The Medicine is Worse than the Disease

© Can Stock Photo Inc. / nebari

Monetary authorities took extreme measures during and after the financial crisis. These policies failed in their stated goal. More importantly, they have the potential for much mischief in the portfolios of the unwary in the months and years ahead.

Fed Chairman Ben Bernanke made it clear that the role of zero interest rates and Quantitative Easing was to push money into productive investments (or “risk assets”) that would help the economy grow. Instead, the biggest tidal wave of money ever flooded into supposedly safe assets, like Treasury bonds. Money flows into US stocks disappeared in the crisis, and basically have never come back. Zero interest worked exactly opposite the way it was supposed to. This obvious reality is totally ignored by the central bankers.

Current Federal Reserve Chair Janet Yellen continues to parrot the party line. Progress toward undoing the mistaken crisis policies has been excruciatingly slow. And the potential for damage to safety-seeking investors continues to mount. Similar policies, or worse, are in effect around the world.

Standard & Poor’s recently issued a report stating that corporate debt would grow from a little over $50 trillion now to $75 trillion by 2021, globally. Bonds are the largest single form of corporate debt, which is how investors are affected. This isn’t happening because corporations are investing so much money in new plants and equipment and research. It is merely meeting the demand of safety-seeking investors for places to put money. We think of this as “the safety bubble.” It appears to be the biggest bubble in history.

Standard & Poor’s is warning of future defaults from companies that borrowed too much money at these artificially low interest rates. Our concern is that when interest rates inevitably rise, people locked into low interest investments will see large market value losses even if their bonds are ultimately repaid.

We’ve written about the impact of higher inflation on today’s supposedly safe investments. Now the warning from S&P highlights another risk. The distortions created by counter-productive monetary policy are growing.

Of course, we believe our portfolios are constructed to defend against these risks, and to profit from the artificially low interest rates. We will continue to monitor these and other developments. If you have questions or comments, please email or call us.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

Deflated Inflation Expectations

© Can Stock Photo Inc. / NataliyaShirokova

We’ve written before about inflation and its corrosive effect over time. The topic has become much more timely because of two developments:

1. The prospects for inflation have gone up with the large increase in the price of oil and other forms of energy. We could potentially see annual inflation indicators top 3% within the next six months.

2. Money continues to flood into long-term low rate fixed income, as safety-seekers buy bonds yielding in the 1 and 2 percent range.

It appears these trends are in for quite a collision. Our first principle is ‘Avoid stampedes in the markets.’ So we suspect that the safety-seekers may not end up with what they were seeking. If today’s 2% bond is repriced in a 3% world, capital losses may result.

Human tendency is to expect current conditions and trends to continue. So the prospects for inflation are pretty much ‘out of sight, out of mind,’ since we have not had much inflation for quite a while. But the large increases in the price of oil and other raw materials could potentially generate annual inflation rates in excess of 3% over the next few months. Crude oil, for example, bottomed at $28 per barrel in February 2016. Current prices in the $40’s, if they persist until February 2017, will exert a lot of upward pressure on inflation.1

One would expect that investors locked in at 2% yields when inflation is running at 3% will not sit still for it. The mystery is, will the stampede of money into bonds come stampeding back out if safety-seekers find losses on their supposedly safe investments?

The potential for profit lives in the gap between expectations and unfolding reality. We believe inflation expectations and corresponding investment yields are off the mark. We have no guarantees, but our opinion is inflation will be up and bond prices will be down in the months and years ahead. If you would like to talk about the ramifications on our portfolios or yours, write or call.

1Oil prices retrieved via Federal Reserve Bank of St. Louis


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.

Bond yields are subject to change. Certain call or special redemption features may exist which could impact yield.

The economic forecasts set forth may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

The Risk You Don’t See

© Can Stock Photo Inc. / larryhw

United States Treasury Bonds have long been considered among the safest investments in the world. But bonds with extended maturities, twenty or thirty years, have a lot of risk. This risk seems invisible and under-appreciated in today’s environment.

How would you like a twenty year long term Treasury bond paying 7%? Would that be good for you? People thought so in 1977. But by 1982 when interest rates had risen to almost 15%1, those bonds were only worth fifty cents on the dollar. Worse yet, inflation ramped up and damaged the purchasing power of interest earnings. When rates rise, the value of existing bonds goes down.

Since the financial crisis of 2007-2009, hundreds of billions of dollars have gone into bonds—a record tidal wave of money. One might guess this represents a flight to safety amid the uncertainties of the world. Some people got hurt in real estate, some were hurt by selling stocks after a crash, and they just want to keep their money safe.

Behavioral economics has shown that we humans tend to believe that current conditions and current trends will continue into the future. So if we pose the question, “What will a 2% bond be worth in a 5% world?,” most people can’t even conceive of the possibility of 5% interest rates. While everybody seems to understand that the stock market goes up and down, few seem to remember that the bond market also goes up and down.

As inflation begins to pick up, investors may be leery of owning 2% bonds that are going backward in purchasing power. If the sellers come out, bond values may decline while interest rates go up. The more selling, the greater the losses, which produces even more selling.

We are not predicting this will happen. But we do know a similar situation happened in the past. Fortunately, we are working on ways to preserve capital without facing the large risk from rising interest rates. If you would like to know more, please call or email us.

1Data from St. Louis Federal Reserve


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.