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OMGI’s Johnson: Should everyone be obsessed with the Fed?

09 June 2015

Old Mutual Global Investors’ head of fixed income looks at investors should view the constant speculation about when the Federal Reserve will increase interest rates.

By Christine Johnson ,

Old Mutual Global Investors

Investment commentary is obsessed with the Fed - when will they raise rates, how much will they raise them, or how quickly? It all rather misses the vital point - most investors aren’t invested in Fed funds.

Base rate investing in the last few years may have given you very low volatility but also would have resulted in very low returns. The world of low rates and oodles of QE has created an ‘ABC’ mentality – anything but cash.  The effects of the Fed raising rates will not be felt by investors in base rates but the consequences will be felt just about everywhere else.

And the ABC mentality has tended to push investors further away from the potential blast zone – those who would have been content in cash now own three-year paper, in turn shorter dated investors find themselves out in the five-year neighbourhood, five-year profiles flirt with the 10-year and so it goes on, until most investors have more maturity risk than they might have cared for in the past.

So what does this maturity business matter? A couple of points of detail first:  to start with, on any medium term measure the curve is pretty flat – you don’t get much more for going further out in maturity, about 0.75 per cent for an extra 20 years of risk. This is largely because everyone’s at it, basic supply and demand, lots of people are hungry for yield and they’re prepared to go longer for it. So, as an issuer there’s little need to offer any incentive. 

The second consideration is that the amount of pain and pleasure is amplified the longer out you go and for the last few years there has been a great deal of pleasure - as yields have fallen and prices have risen – and very little pain. For all but the most unconventional souls this tempts people to stay; the memory of past pleasures encourages one to linger.  Breaking up is hard to do.

And history might encourage you to do so – conventional rate rising episodes have been associated with flattening curves, that means that although yields rise all along the curve they rise more in the shorter dated end so on a cash weighted basis, short-dated bonds perform worse than the long dated. Indeed 2004 enjoyed an extraordinary episode when 30-year bond yields fell … while the Fed was raising rates (see chart).  Much airtime has been given to this recently, supporting the ‘flat curve’ argument.

2004 – 2006 rates rise and yields fall

 

Source: OMGI, Macrobond

Receiving more airtime and for longer however has been the phrase ’unconventional policy’. Unconventional policy in the shape of extremely accommodative rates and QE are not likely to be conventional in their unwinding. Partly because the Fed has made the curve flat on purpose through their ‘Operation Twist ‘ project three years ago in which they bought long dated securities instead of short dated securities with the explicit intention of flattening the curve.

This was back when the housing market was the ‘Big Thing’ and our waking hours were consumed pondering refinancing rates.  But now the Fed – and the Bank of England for that matter – finds curves to be too flat. The phrase ‘term premium’ has made an appearance – and it is, we are told, too low. ‘Term premium’ is the price of uncertainty – the longer you commit your money the more you should be compensated for the possibility that things don’t go exactly to plan.

If the Fed regards the term premium to be too low and the curve too flat, there is something they can do about it without touching base rates - or at least while raising base rates very, very, slowly. They can just let the passage of time eat away at the maturity of what they have on their balance sheet and that will erode the underpin to long rates. This year and early next, mortgage bonds and then government bonds the Fed owns will mature – what they choose to do with the proceeds will be important.

But there are other reasons why things may be different this time.  It’s not whether the Fed is raising rates, it’s the circumstances under which it is doing it and how quickly. In conventional rate hike cycles, central banks start hiking rates to slow the economy, domestic inflation is rising and things are getting overheated. Rate rises are brisk and multiple and quite quickly reach the level where they have peaked.  That allows the prospect for rates later on to be the same or indeed lower than rates today – the curve flattens.

If the Fed is to start raising rates very slowly when the current pressure from domestic inflation is low, they are fuelling the possibility for inflation to be much higher later - uncertainty is on the rise. The Fed is behind the curve and the anchored short end gives way to higher yields further out.

But before we get too hypothetical let’s quantify some of these worries. Whatever happens, yields in the 30-year area will probably rise and all the way out there little rises can do a lot of damage – a year’s worth of yield destroyed by a 20bps rise. If your investment parameters allow you, be short. Otherwise non-ownership shouldn’t cause you much harm.

Owning shorter dated bonds seems an easier option – the short end is anchored unless circumstances change dramatically. When it comes to reward versus risk, reaping a higher yield for the same interest rate risk gives you some insulation: here carry (additional income) is still your friend.

Lots more yield gives you lots more protection; short dated credit may move around but your one year holding period has a much higher chance of being meaningfully positive if you start with a 5 per cent yield for three years’ worth of risk than if you start with a 1 per cent yield.

Christine Johnson is head of fixed income at Old Mutual Global Investors. The views expressed above are her own and should not be taken as investment advice.

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