This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Scott Kubie, chief strategist of Omaha, Nebraska-based CLS Investments.
This past May 18 stands out among trading days. It was special because a minimal number of variables affected markets.
On that day, the Federal Reserve dominated the news by finally convincing investors to raise their expectations (at least temporarily) for a rate hike in June or July. British polling data released the same day showed polls trending against the Brexit. And that was about it.
Rarely does one day provide such clarity regarding how asset classes were influenced by expectations of rate hikes from the Federal Reserve. The performance that day also gives insight into why bonds have performed well since the first rate hike and how market expectations would need to adjust if the Fed follows through with two hikes and the economy continues to improve.
How Many Hikes Do You Have In You?
Investors anticipated the Fed would continue to lower expectations for rate hikes toward those reflected in the futures market. As many have noted, investors pushed prices for long-term bonds higher after the sole Fed rate hike last year. Investor reaction since the last hike communicated to the Fed that it made a mistake that will need to be reversed.
This view prevailed until the Fed, in the minutes from its last meeting, expressed disagreement with this reasoning by pointedly raising expectations for how quickly rates will increase.
Even after the terrible job numbers on June 3, 2016, I believe the Fed will raise rates twice by the first meeting of next year. Market-implied expectations reflect deep uncertainty. Odds for one hike remain above the odds for two hikes. The odds for no hikes in 2016 remain fairly high as well. This was even truer in mid-May when the Fed released minutes that deliberately pushed investors toward its point of view.
While Fed decisions affect almost every asset class, the performance on May 18, 2016, helps identify those asset classes likely to be affected positively and negatively by a rate hike and the linkages between them.
Bonds did not welcome the news of potential hikes. The performance graph above shows a decline in longer-duration assets. The Federal Reserve minutes communicated two powerful messages. First, investors are underestimating the willingness of the Fed to raise rates. Second, investors are underestimating how quickly economic gains are removing slack from the economy.
On May 18, long-term Treasury bonds, such as the iShares 20+ Year Treasury Bond (TLT | A-83), lost more than 1.5%. TIPS and 7- to 10-year Treasury bonds both reacted poorly. Some had predicted continued yield-curve flattening, but may have misjudged how small increases in yield can swing prices of high-duration securities.
Investors should focus on short-duration TIPS (PIMCO 1-5 Year US TIPS Index ETF (STPZ | A-74)), and use very small positions in long maturities (TLT) and areas where the yield curve is steep (the iShares 3-7 Year Treasury Bond ETF (IEI | A-73)) to supplement returns.