Income Investor Perspectives

What’s the best way to time interest rates?

“Shouldn’t I just wait for rates to go higher?”

“When are yields going to be more attractive?”

“What will be the signal that rates are going to start moving?”

“What’s the best way to time interest rates?”

If these comments strike you as familiar, it is because these are some of the same questions that income-hungry investors have been asking for years—and now, with the Fed seemingly closer to finally raising the fed funds target rate, the thirst for higher more attractive yields has intensified.

Answering these questions in context, however, also requires addressing several key investing ideas, including:

• Portfolio diversification and how much to allocate to bonds (and, therefore, also to cash and equities)
• How much income you want or need is a function of your lifestyle—not of the market: your goals should be mapped out and described in your investment plan or policy
• Understanding what influences interest rates and how to invest through the economic/interest rate cycles

The way that an investor deals with the first two points will be helped or hindered depending on how they deal with the third point.

This article will discuss how to time interest rates, and we will discuss the other issues in future articles.

How to time interest rates

You cannot time interest rates.

If you listen to or read some of the commentators, you may think that you can. Over the near term—maybe. But over the longer term, while directional forecasts may be helpful, the timing and magnitude of interest rate changes are subject to changes in so many factors that they cannot be reliably forecast with precision. (See Note 1) Would you rely on a weather forecast that purports to show a chance of rain in 24 months? Of course not. The number of variables that must be considered, and the number of assumptions that would have to be made mean that calculating a precise answer might provide a number, but that it would not have a high degree of reliability.

Consider stock price forecasting: Apple (NASDAQ: AAPL) is covered by research analysts at 42 brokerage firms. Apple’s business is well-known and while its products (and supply chain) are complex, its product offering is fairly simple and understandable. Company management is experienced and forthcoming about what they are trying to achieve and the company provides an abundance of data. Yet there is a wide variation among what the 42 firms are expecting for Apple’s stock price. According to Thomson/First Call data provided by Yahoo Finance, the stock price target ranges from $60.00 to $150.00. (As of December 5, 2014.)

The U.S. and global economies and interest rates are infinitely more complex than the business of a single company.  (See Note 2)  So if there is not agreement about the price target for Apple stock, is it reasonable to expect that interest rate forecasts will offer higher confidence?

In the U.S. bond markets, while there is general recognition that two of the most important factors are monetary policy and inflation, these are not the only factors that influence bond yields. (Investors waiting to make a portfolio move when the Fed begins raising rates may miss out on the move to higher yields, as bond yields have historically moved in advance of when the Fed takes action.) The list below is surely not complete, and is intended to suggest the difficulty of accurately predicting future interest rates.

Here is a list of many but not all factors that can affect interest rates; its length alone is intended to suggest the difficulty of accurately predicting future interest rates.

Domestic monetary policy
Domestic inflation
Bond market liquidity levels and money flows
Balance of payments
Commodity prices
Demographic trends
Economic and business trends
Elections
Employment
Energy prices
Equity markets
Fiscal policy (government spending)
Foreign exchange prices
Foreign / global inflation rates
Historical market behaviors
Foreign / global monetary policy
Household wealth levels
Housing prices, new home formation
Investor sentiment
Legislative / regulatory changes / uncertainty
Levels of foreign trade
Loan demand
Other interest rates
Supply and demand dynamics of important securities
Supply and demand dynamics of the bond markets
Tax rates
Technology and the accelerating pace of technological change and the impact on the economy (such as productivity, employment, etc.)
Unexpected news (“black swan” events)
Wars or threat of military action
In addition, as economies around the world have become more interlinked, the factors above would have to be considered both domestically and globally, with assumptions for both current and future conditions. Adding further complexity is the fact that the correlations among factors can fluctuate.

Also, models can account only for quantitative inputs. The “animal spirits” of the markets cannot all be measured—qualitative considerations cannot be reduced to an Excel spreadsheet, and are, therefore, frequently ignored. Regardless of how well-informed the assumptions are, the longer the time frame or proposed precision of the forecast, the greater the skepticism that should be applied. Economist Friedrich Hayek cautioned about this point in his Nobel Prize acceptance speech. He counseled being “apprehensive” regarding “the uncritical acceptance of assertions which have the appearance [emphasis Hayek’s] of being scientific.” (See Note 3)

So what is an investor to do?

If it is impossible to accurately forecast future rates, should investors ignore interest rate forecasts?

No. Doing so would be irresponsible. What is important is to recognize the limitations of forecasts and to treat them as one input in the investment decision-making process.

While all investors are seeking a return on their investment, the prudent investor recognizes that at some point in time, all markets will go down, creating opportunity for buyers, but also risks for those forced to sell. The best way to manage these risks is with a balanced portfolio. What Benjamin Graham wrote in The Intelligent Investor in 1949 remains applicable.

“Our readers must have enough intelligence to recognize that even high-quality stocks cannot be a better purchase than bonds under all conditions. A statement of this kind would be as absurd as the contrary one—that any bond is safer than any stock.”

In other words, it is sensible to include both asset classes in an investment portfolio. (The more interesting question is deciding what percentages to allocate to each asset class, but we’ll save that discussion for another time.)

So an investor (and the trader) (See Note 4) should have an understanding of what their appropriate allocation to fixed income would be, and if the interest rate environment is more likely to trend in one direction than the other, then that bias could be reflected in what kinds of bonds (or professionally managed strategies) the investor selects. Stated more simply, let prevailing market conditions influence which bonds you buy—not whether or not you buy bonds at all.

Many bond investors employ a laddered portfolio strategy—a standard “all weather” approach because a laddered portfolio is considered interest-rate neutral, as it favors neither a rising nor a falling rate environment. With a laddered portfolio, equal percentages of the fixed income allocation are invested in serial maturities coming due over a period of years; for example, from 1 to 10 years, from 1 to 15 years, etc. With rates biased higher, however, an investor may wish to modify their ladder by concentrating more principal in the shorter maturities to allow some of the principal to be reinvested in longer maturities to lock in then-higher rates.

Given the growing expectation for higher rates, investors could consider being underallocated to fixed income or underweight duration, in both cases to retain the flexibility to shift into higher rates if and when they arrive.

A mutual fund investor could employ a similar strategy by pairing several funds of differing durations so that the shorter duration fund could be a source of price stability should rates rise, and could also be swapped into longer duration funds when rates are higher. Extra diligence is warranted though, as mutual funds, unlike individual bonds, will not shorten in duration nor mature at par.

Investors with sufficient portfolio size may also wish to consider professionally managed strategies that will opportunistically shift duration or allocations within the fixed income asset class as market conditions shift.

By underallocating to bonds, investors may unwittingly be taking on more risk by missing out on the diversification benefits of holding bonds with their stocks. We believe it is unwise to try to time interest rates, and suggest instead to mitigate the risks of a rising rate environment by adjusting within fixed income (which specific investments you own), rather than shifting your asset allocation.

Notes:

1. In defense of the commentators, their opinions are often directed to traders seeking to take advantage of near-term market inefficiencies and opportunities. (Investors—who may have a percentage of their portfolio allocated to pursuing trading opportunities—should be interested first and foremost on making progress towards their long-term goals. So when investors hear a comment such as, “Get out of bonds because rates are getting ready to go higher,” they should be mindful of the difference between the objectives of their trading portfolio and their investment portfolio. We plan to explore this distinction further in future articles.)
2. Ironically, many of the individual investors who no longer try to time their equity market investments have been known to try to time interest rates.
3. The entire speech is worthwhile reading for any investor or student of economics. “Friedrich August von Hayek – Prize Lecture: The Pretence of Knowledge”. Nobelprize.org.Nobel Media AB 2014. Web. 7 Dec 2014. http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/1974/hayek-lecture.html
4. A trader is an investor trying to take advantage of price moves. Trading successfully requires consistently selecting the right securities, and the right entry and exit points (prices and times). Trading in the bond market is not impossible, but due to the number of influences and complexities of the markets, it is very difficult for the individual investor to successfully out-trade professional money managers.

Timing Interest Rates
Income Investor Perspectives

Exploring ideas of interest to the income investor

December 8, 2014

The information contained herein is based on sources believed to be reliable, but its accuracy is not guaranteed. The author does not provide investment, tax, legal or accounting advice. Investors should consult with their own advisor and fully understand their own situation when considering changes to their strategy, tactics or individual investments. Investments in bonds are subject to gains/losses based on the level of interest rates, market conditions and credit quality of the issuer. Additional information available upon request.

©2014, 2017 Patrick F. Luby

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