Will 2014 be the year that rates finally move up? My Magic Eight Ball says, “All signs point to no....ish.” Like 2013, rates will move up, then down (and we will all be surprised by when and how much). But from a 30,000-foot view, in terms of start to finish variance, it is likely to be another relatively uneventful year for interest rates. That is not to say there will not be dislocation. Last year’s cruel summer will not soon be forgotten. Gains wilted, losses bloomed, durations extended, concerns mounted and managers reacted.
The 2013 “taper tantrum” prompted some portfolios to embrace managing to a shorter duration and amassing large cash positions (earning nearly 0 percent). While that approach will stem portfolio losses when rates rise, it immediately diminishes current income. Does this sound familiar? Surveys suggest portfolio managers have positioned for higher rates since the Great Recession began. And until mid-2013, they have been disappointed year after year. Will 2014 be the year rates return to long-term norms? Two arguments suggest otherwise. And though there are reasonable arguments for higher rates, this piece will address technical analysis supporting the contrary.
Statistical Regression Analysis
Regression analysis is predicated on returns to the mean and is well suited for studying long-term interest rate trends. The further any variable (e.g., interest rates) varies from its statistical mean, the greater the probability the variable will return to the middle. Standard deviation is the measuring stick of any regressed data. One StdDev is thought to account for 67 percent of likely outcomes while two StdDev is covers 96 percent of possible outcomes. Thus, once two StdDev is achieved, there is less than a 4 percent chance that an outcome further from the mean will follow. As a forecasting tool, we study 10 years of interest rates and regress the 120 monthly data points. The goal is to understand where we are in the cycle and how likely, or unlikely, a reversion to the mean may be. While this analysis does not account well for magnitude and timing, it is a successful directional indicator. As illustrated below, over the past 10 years rates have predictably trended back to the mean as one or two StdDev are achieved. Thus, higher rates beget lower rates and lower rates beget higher rates.
Technical Support and Resistance
For centuries, investors and historians have used technical analysis to forecast or chronicle myriad markets and outcomes. Support and resistance charting is a common tool for technicians who study price action for a glimpse of the future. This is a variation of regression analysis and is said to be an oscillating indicator. When the price of something (e.g., bonds) moves in a range, an oscillating indicator helps to determine the upper and lower boundaries of that range by flashing whether the observed market is overbought or oversold. Not surprisingly, chartists study this through measured observance over certain time periods. Oscillating indicators tend to be leading in nature. There are several examples with subtle refinements (e.g., the Relative Strength Index, championed by Welles Wilder). Support and resistance charting is a common tool for bond market prognosticators. Today’s forecast suggests that until the 10-year Treasury breaks through 3 percent and can maintain these higher levels, we will continue the same trends of flat/lower rates in the near term.
What does this all mean? We’ll find out together. But in the interim, do not let your fears/biases of higher rates get in the way of potential earnings. There are several ways to protect yourself from higher rates without sacrificing earnings. Look to structures like 10- and 15-year agency MBS pass-throughs, 5/1 (or seasoned 7/1) agency ARMs, high-coupon municipal “kickers” and non-callable agency bullets.
When rates do move higher, short duration and steady cashflows will be in demand. Until then, 5/1 agency ARMs with 5/2/5 CAP structures, wide margins and low premiums will see you through. This particular structure cashflows steadily, resists extension and tends to hold its value with the potential to reset up to 500 bps at the first reset. You may also consider seasoned 7/1 agency ARMs, which can fetch higher margins and lower premiums.
For tax-free income, focus on high-quality, high-coupon municipal bonds issued as general obligations or essential-purpose revenues with short or intermediate call features. They trade at taxable equivalent yields well beyond taxable products and offer price protection via the high coupon you will own at par (having amortized the premium) should the issue not be called.
Lastly, if you want to keep it simple and maximize the opportunity for gains if rates fall, buy non-callable agencies (aka bullets). The curve is steep and the opportunities are plentiful. The short and intermediate points on the agency bullet curve currently offer anywhere from 27–46 bps of additional yield (read: price protection) year to year.
Portfolio managers have various tools to sculpt a portfolio to a certain rate bias. Regression analysis and price charting are just two in your toolbox that will help navigate the choppy waters of fixed-income investing. If loan demand is slack, funds are piling up and you are looking for a lead … lose the Magic Eight Ball and chart it out.
Josh Kiefer is vice president in the Capital Markets Group at Country Club Bank, Kansas City.
Copyright February 2014. BankNews Media