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.