The inflection point of The New Interest Rate Paradigm suggests several key conclusions, which effect long-term bond returns, asset allocation, risk management, and portfolio construction:
1. FOMC under new management within a year, so rule-based Hawks likely to trump capricious Doves
2. Rapidly evolving asset class risk measures, particularly volatility and correlation
3. Correcting imbalances and unwinding bloated central bank balance sheets due to QE.
4. Increasing sovereign bond risk of extended global debt and rising interest burdens as yields increase.
5. Higher potential growth and equilibrium inflation as tax and regulatory reform increase competitiveness
6. Consequences of increased duration and bond leverage used by asset owners and hedge funds
7. Financial Reform–Part II and bond market illiquidity
Interest rates have remained too low for too long and now must normalize more quickly given the wide gap to traverse from ¾-1% to 3.5%. Normalization requires adopting a systematic program similar to 2004’s cycle, instead of an arbitrary mantra of “data dependency”. We expect to reach equilibrium sooner at a level more consistent with the long-run average than generally assumed. The window of opportunity for a slow methodical program is closing with a wide gap to the Taylor Rule’s indicated Fed Funds Rate, already exceeding 2.8%.
Interest Rates 2016 2017 2018 2019 Longer Run
FOMC Avg. 0.63% 1.40% 2.32% 2.89% 2.99%
SFM Forecast 0.63% 1.75% 3.25% 3.50% 3.50%
SFM Hikes 0.25% 1.00% 1.50% 0.25% -
Source: FOMC Economic Projections for March 2017
Reducing balance sheet holdings includes refunding $1.4 trillion of maturing Treasuries within the next five years. Investors may be surprised when the Federal Reserve ceases its bond reinvestment program.
Global debt has soared to $230 trillion, with $60 trillion of total U.S. debt. High demand for long bonds facilitated unchecked bond issuance at exceptionally low rates. The New Interest Rate Paradigm suggests such imbalances must reverse resulting in persistent negative real bond returns over several years.
A three decade long bond bull market also led investors to adopt unrealistic bond market return, risk and correlation assumptions. Correlations and volatility are evolving more quickly now with increased economic dispersion, an inflection point in interest rates, and The New Interest Rate Paradigm. Investors seem too sanguine about global bond risks, and should be vigilant about the global impact of bond market losses as yields rise.
Here is another critical point: Rising bond yields will likely overshoot with persistent negative real bond returns for 3-5 years that could drive an excess inflation risk premium exceeding +0.5% and a steeper yield curve that further increases cost of capital for global debtors.
Investors must appreciate the effect of still high bond convexity, which increases interest rate sensitivity at low interest rates. Leverage and extended bond duration will compound losses as yields rise further as never before due to high convexity, with surprising bond losses for just a 1% change in yield.
While unusual to raise interest rates with such low inflation, risks are increasing. Emerging clear and present inflation is revealed as effects of oil price declines and U.S. dollar strength have sunset, causing convergence in headline and core (ex-food, energy) inflation below. Thus, interest rates need to rise toward equilibrium well ahead of the next inevitable recession, and before needing to hike rates more aggressively.
Thus, we should ask a marvellously simple question: What is long-term U.S. inflation—the FOMC says long-run PCE inflation plunged from 3% to 2%, but we think it will again be closer to 3%. We suggest tax and regulatory reform restores 2.7% potential growth. Long-run estimates of the Fed’s 1.8% real growth and 2.0% inflation seem misleading, in our opinion. Realizing higher than anticipated growth and inflation could drive a parallel shift or steepening yield curve, meaning that bond yields will rise as much as short-term rates.
Control of the Executive Branch provides an opportunity to appoint significant decision makers. Three vacancies on the Board of Governors at the Federal Reserve are appointed for up to 14 years, coinciding with expiring terms of the Chair and Vice-Chair in early 2018. The dovish FOMC is likely to be under new management within a year. Reform of Dodd-Frank legislation will result in significant new rulemaking both at the Federal Reserve and SEC, which also has a vacant Chairmanship.
Differences unfolding in fiscal, monetary, interest rate and regulatory policy have resulted in greater cyclical divergence. Global economic divergence and monetary inflection points are a precursor to dispersion in asset class, country, sector, and risk factor returns. This should increase investment opportunities and international diversification, while providing exceptional global tactical opportunities. Currency management and hedging also has become more crucial. Greater uncertainty will not necessarily drive higher equity volatility, although an inflection point in interest rates should drive higher bond and currency volatility.
Finally, increased fixed income illiquidity risk seems underappreciated, while difficult to measure and challenging to hedge. It will exacerbate volatility, particularly for countries with high debt levels. Higher U.S. yields will lift global yields, and adversely impact other rate sensitive investments. Safe haven and income darlings may become toxic with higher rates, including low volatility, high dividend yield, long bonds, gold, risk parity, and certain alternatives. This is a new paradigm, and far from any new neutral investors might envision.
Potential causes of a financial crisis should be quite different than in the past, and likely rooted in unsustainable global debt and fiscal deficits, in our opinion. We have argued that policy normalization is needed, and should progress steadily as long as growth is modest and the likelihood of recession remains low. Rising bond yields and market illiquidity will expose financial imbalances and overexposure to interest rate sensitivity, crippled by extensive global debt that risks crowding out normal credit creation.
