3/13/2015 @ 4:17PM
Steve Blumenthal, Contributor
We’ve gotten used to thinking of a zero interest rate as normal-—it’s far from normal.”
-Fed Vice Chairman Stanley Fischer
Employment figures continue to surpass analyst estimates and the trend over the last six months has been strong. Last Friday’s upside surprise sent interest rates higher. It is expected that the Fed moves off its zero bound peg by September.
“June has to be on the table,” adding that as the economy meets his expectations, “June would strike me as the leading candidate for liftoff” in moving short-term interest rates off their current near-zero levels… quoting Federal Reserve Bank of Richmond President Jeffrey Lacker.
Liftoff is likely just the beginning of the journey. That popular song rings louder in my head, All About That Fed. The problem with rising rates is that bonds lose money, especially when your starting place is ultra-low yields.
Confusion deepens the more you turn on CNBC. One expert shouts rates are going higher. The next argues they’re headed lower. Both make a good case.
I mentioned in my outlook piece that “this is the year that interest rates will finally rise.” I believe the Fed feels it is time to begin normalizing rates. Additionally, defaults in the high yield market will likely climb with the result of re-pricing risk (higher interest rates). One could argue that money ultimately moves to where it is treated best, so given the negative interest rates in Europe and relatively high rates in the U.S., coupled with a loss of confidence in sovereign bonds (Greece, Spain, France, etc.) money will rush to the dollar and into U.S. Treasury bonds (driving prices higher and rates lower).
Another might say that both Europe and Japan are beginning QE and they, like the U.S., will see improvement in their economies and be successful creating inflation. Thus, interest rates will move even higher. Will that view prove correct? Maybe. Will my view prove correct? Not sure. There are no guarantees when investing.
Twenty-five Wall Street economists felt interest rates would rise in 2014 to an average of 3.25%. They were ALL wrong and missed the fourth best performing year in the history of the U.S. bond market.The 10-year Treasury finished the year at 2.20%.
With such confusion, highly common in the investment business, I do believe there is something that you can do today that can help you cut through all the noise.
Implement a defined investment process that allows you to stay in sync with the bond market’s primary trend. Importantly, one that may move you away from rising interest rate danger.
I have long favored a tactical trend model created by the late great Marty Zweig in the mid-80s. Marty looked at data going back to 1967 and established a process that follows five simple steps.
We recreated the model with the help of our friends at Ned Davis Research. The following chart shows the performance of the model (the blue Model Equity Line) vs. the Barclays Aggregate Total Return Index (the black line). Note in the bottom right section of the chart the annualized performance on “buy” signals vs. “sell” signals. The yellow highlighted area reflects the current active signal.
Overall, the Zweig Bond Model has done a good job at enhancing return and reducing the risks present in rising rate environments. It moved to a “sell” signal on March 9. I like that it is a rules based way to identify the primary trend. It is signaling that higher rates may be ahead but note it is a tactical process and should be followed closely if the trend evidence changes.
You can click here to see how it works. There are just 5 simple rules to follow to identify the trend in interest rates.
It is important for portfolios to have exposure to bonds, but with yields so low, risk is actually elevated. I believe now is the time to think more tactically. Here isthe idea:
On “buy” signals, own longer-term bond ETFs such as iShares Barclays 20+ Year Treasury Bond ETF (“TLT”), Vanguard’s Total Bond Market ETF (“BND”) and/or iShares Core U.S. Aggregate Bond ETF (“AGG”). AGGclosely tracks the Index used in the Zweig Bond Model; however, there are many long-term dated bond ETFs that you can use. Find one that trades commission free at your custodian.
On “sell” signals, switch to shorter-term dated bond ETFs such as SPDR Barclays 1-3 Month T-Bill ETF (“BIL”), Vanguard Short-Term Bond ETF (“BSV”) and iShares Barclays 1-3 Year Treasury Bond Fund ETF (“SHY”). Short-term bond market exposure will perform better when interest rates rise, giving you the opportunity to switch back to long-term exposure – hopefully at a higher yield. Clearly, not every signal will prove correct and while the strategy doesn’t trade too frequently, it is the big down trends we want to protect against.
The risk of rising interest rates is material. In the next chart, you can see the impact each 1% rise in rates has on both 10-year and 30-year Treasuries. Should rates rise 2%, the bonds will decline approximately 16% to 32% in value (red circles). Should rates move lower by 1%, gains will be approximately 9% and 23% (green circles). Today the 10-year Treasury is yielding just 2.09%.
While Wall Street economists missed, the Zweig Bond Model remained bullish on longer-term bond ETFs in 2014. It is important to state that,while I believe the process to be solid, there are no guarantees in this business.
If you choose to trade following the Zweig Bond Model process or any other process for that matter, there are several important questions to ask yourself: Do you have the time to follow the model every day? Do you have the infrastructure in place to trade across multiple accounts? Can you execute ETF trades with little market impact and trade for very low commission? Do you have the conviction and belief necessary to follow the process through both losing trades and winning trades? Can you stick to the process over time?
A popular saying on Wall Street is “the trend is your friend.” I believe that to be true and the Zweig Bond Model has donea good job over the years at identifying the major interest rate trends.
Rates are very low today and the Fed looks to take its first step towards “normalizing” interest rates. That says to some that rates are heading higher. Others think deflation and lower rates lie ahead. I think global capital flows to U.S. dollars may ultimately drive our interest rates lower.
Who’s right? Such are the risks we investors must take. Trend evidence helps you stay in line with the bond market’s primary trend. Now is the time to be tactical.
This article is available online at: http://onforb.es/1x2hY93.