Swedroe: Ignore Interest-Rate Noise

In 1905, philosopher George Santayana thought it prudent to remind people about the important role history can play in determining a present or future course of action. He warned: “Those who cannot remember the past are condemned to repeat it.”

This admonishment can apply to the potential for a rise in short-term interest rates initiated by the Federal Reserve, as well as investor expectations for how such increases might negatively impact intermediate- and longer-term maturities.

For the last six years, we have heard a great many clarion cries from market observers warning that the Fed’s zero-interest-rate policy and quantitative easing (bond-buying) program would soon lead to inflation and rising interest rates. Their advice was to avoid longer-term maturities.

Investors who followed such counsel missed out not only on earning the term premium available over this period, but also on securing capital gains created by falling interest rates. What’s more, they suffered reinvestment risk as rates across the curve flattened.

The warnings to avoid longer maturities not only continue, but have gathered additional impetus now that the Fed has signaled the likely end in the near future to its zero-rate policy.

As a result, I’ve received a growing number of questions recently from investors concerned about extending maturities. Given the large amount of attention being paid to this issue, I thought I’d share my response.

Reasons Not To Heed Bond Warnings

To begin with, there’s no evidence that bond market forecasters can accurately predict interest rates any better than the market can. Consider the following anecdote, which I find quite humorous, regarding the ability of forecasters to get it right. Every month, Bloomberg conducts a survey of economists, polling them about the expected direction of interest rates.

In January 2014, 97 percent of the economists Bloomberg surveyed anticipated interest rates would rise within the next six months. With the yield on the 10-year Treasury note at 2.7 percent, the April survey showed that 100 percent of the 67 economists surveyed expected rates to rise within the next six months. Six months later, the yield on the 10-year Treasury was just 2.2 percent. Yes, 100 percent of economists were wrong.

Returning to Santayana’s warning, let’s go to our trusty videotape, hit the rewind button, and review the two most recent episodes in which the Fed tightened monetary policy to evaluate its impact on intermediate- and longer-term maturities.

The Inflation Fears Of 1994

Beginning in early 1994, fears of inflation led the Fed to act preemptively and increase the Federal Funds rate target seven times (by 25, 50 and, on one occasion, 75 basis points).

At the beginning of 1994, interest rates on three-month, five-year and 20-year Treasurys were 3.2 percent, 5.3 percent and 6.5 percent, respectively. By the end of 1996, interest rates on the same issues reached 5.2 percent, 6.2 percent and 6.7 percent, respectively. The Federal Reserve’s website doesn’t provide yields on one-month Treasurys for 1994, which is why I used the three-month rate.

The yield curve “flattened,” and the short end of the curve took most of the brunt of the impact of the Fed’s actions. The three-month rate increased 2 percentage points, while the five-year rate increased 0.9 percentage points and the 20-year rate increased just 0.2 percentage points.

For the period from 1994 through 1996, the returns on one-month, five-year and 20-year Treasurys were 4.9 percent, 5.3 percent and 6.4 percent, respectively. Thus, there was no benefit from staying short even if you fully anticipated the Fed would raise rates when—and as aggressively—as they did. The reason for this was that the market had anticipated much of the increase, and the yield curve was positively sloped.

2004’s Fed Tightening

The next episode of tightening by the Fed came in 2004. Over a 24-month period, the Fed raised rates 425 basis points, from 1 percent to 5.25 percent. At the start of 2004, the yields on one-month, five-year and 20-year Treasurys were 0.9 percent, 3.4 percent and 5.2 percent, respectively.

At the end of 2006, the yields were 4.8 percent, 4.7 percent and 4.9 percent, respectively. Here, again, it was the front end of the yield curve that took the brunt of the Fed’s actions. And once again, the yield curve flattened.

In fact, the yield on the 20-year Treasury bond actually fell. For the period from 2004 through 2006, the returns on one-month, five-year and 20-year Treasurys were 3.0 percent, 2.3 percent and 5.8 percent, respectively.

In this case, while the one-month Treasury outperformed the five-year bond by 0.7 percentage points, it underperformed the 20-year Treasury by 2.8 percentage points. Again, even if you accurately predicted the timing and amount of increase in short-term rates, there doesn’t seem to have been much, if any, advantage in staying short.

The bottom line is that while yields are still at historically low levels and a period of tightening by the Fed seems to be just around the corner, those aren’t sufficient reasons to avoid taking at least some term risk. The current yield curve is still positively sloped, indicating the market is already anticipating that rates will rise.

In other words, you can only benefit from staying short should interest rates actually rise faster and/or more than already expected. And there’s overwhelming evidence that those who try to outguess the market when it comes to interest rates are playing a loser’s game.

So just like at the craps table, roulette wheel or slot machines in Las Vegas casinos, the surest way to win a loser’s game is to choose not to play. Instead, you should stay disciplined and adhere to your investment/asset allocation plan.

Consider ignoring all interest rate forecasts and build laddered portfolios with an average maturity typically of about four to five years. That maturity balances the two risks of maturity (inflation) and reinvestment.

Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.