Expectations about interest rates change because of the news every day. This makes it very difficult to build an investment strategy around a forecast, so we don’t do that.
In a recent article, Bloomberg News noted that the rally in the US Treasury market in 2014 was stronger than every economist surveyed by its journalists had predicted. Yes, stronger than every one of 66 economists polled!
US 10-year yields were around 2.3% at the end of August, down from just over 3% at the end of 2013. Yields fall as prices rise, so those who heeded economists’ forecasts and sold their bonds missed out.
But this isn’t just a US story. Japan’s 10-year government bond yield hit its lowest levels in 16 months in late August and European bond yields tumbled to record lows.
Why did many economists get their interest rate calls wrong? The sarcastic answer would be “habit.” Most pundits have been getting it wrong on interest rates since 2007 or 2008.
There could be a variety of real reasons for their getting it wrong. Economic growth and inflation may have been below their assumptions. Geopolitical strains may have dampened risk appetites. Central banks may have adjusted their timetables for withdrawing monetary stimulus.
Just like with stocks, the important point is that unless you have a way of forecasting the news every day, you are unlikely to enjoy consistent success in basing your fixed income strategy on anticipating changes in interest rates.
Fortunately, there is another way of managing fixed income, one that doesn’t require predicting interest rates. It involves diversifying globally and using the information in the market at any one time to work out which parts of the market to invest in.
The benefits of diversification come from the fact that interest rate cycles can vary across economies, reflecting differences in expectations for inflation, economic growth and other indicators.
For example, while rates in many economies remain at record lows, New Zealand raised its cash rate four times since March. While markets anticipate the Bank of England raising rates, there has been speculation the European Central Bank will announce further stimulus to ward off deflation.
Because interest rate movements aren’t correlated, buying bonds globally can reduce volatility in an overall portfolio. This is the argument for global diversification—not betting everything on a single market.
The second part of this non-forecasting approach is to vary maturities in a portfolio depending on the state of the yield curve. The yield curve is a graph that compares the yields of similar sorts of bonds of different maturities.
A normally sloped yield curve is upward sloping—reflecting the additional return investors would want for tying their money up longer, meaning longer-term bonds pay higher yields. This is called “term risk” and we all see it when we look at CD rates. You get paid more for giving the bank your money longer. Sometimes, yield curves can flatten or invert. This is when there is little or no premium on offer for tying up your money for longer periods.
So if the yield curve is upward sloping, it may pay to take more of this term risk because you are being compensated for it. Conversely, if the curve is flat or inverted, there is little or no compensation for taking on the term risk, so you may stay in shorter-dated bonds.
This approach uses no forecasting, market timing, or assumptions about the direction of interest rates. It uses today’s yield curve to work out where to allocate term risk in a portfolio. And treating bonds as a global asset class provides a larger set of yield curves to choose from—more opportunity, more diversification.
There is significant evidence that correctly forecasting interest rates with any consistency is impossible. But we can seek to control exposure to risk, cost, and diversification.
Of course, everyone has an opinion about the interest rate outlook. That’s fine. We just don’t invest based on them.
