Every now and again, the market gods give advisors a mulligan — the opportunity to correct a mistake on behalf of their clients. We believe this is one of those times, but that there’s a short window in which to act upon it.
Interest rates have been steadily rising for over a year, reversing a decades-long bull market aided and abetted by a historically accommodating monetary policy. Using the 10-year Treasury as our benchmark, rates declined from a peak of almost 16% in September 1981 to a historic low of 0.53% in July 2020. The current bear market in bonds saw that rate climb to a recent cyclical peak of a little over 3.13% in early May.
If your clients hold a fixed-income portfolio that resembles the broad market
And then, a strange thing happened. Over the past several weeks, medium- and long-term interest rates actually retreated a bit. Since their peak in early May, the 10-year has fallen by about 38 basis points. AGG has gained back about 2 1/2 basis points of performance.
You might be tempted to think the worst is over and that you can return to your regularly scheduled program. We think you would be wrong. Inflation in the U.S., and indeed in most of the world, is not abating and no amount of wishful thinking will make it so. Wage pressures, supply chain disruptions, massive overhang from the Fed’s quantitative easing and other pressures are now fully embedded. It is going to take an extended period of tightening monetary policy to bring inflation back down to the
Instead, we believe you should see this recent bond rally as a classic head fake that should be used as a unique opportunity to reduce the level of interest rate risk in your clients’ portfolios. If you didn’t take such actions earlier this year, this is a potential gift that you would be wise to treasure. It is now a good bit cheaper than it was just a few weeks ago to reduce duration in your clients’ fixed income portfolios, better preparing them for the resumption of the trend toward higher long-term rates that we believe is just getting started.
Forecast: Continued reality
Fed messaging around its policy goals is a massive muddle at present. They swing from a hawkish, “We’ll do what is needed to stop inflation” to a dovish “Let’s wait and see” stance on a weekly, or sometimes daily, basis. To borrow a phrase, “reality bites.” Sustained inflationary trends like the one we face now don’t simply dissipate with the passage of time. If anything, left untreated, inflation tends to worsen, accelerate or even spiral out of control.
This is going to become ever more clear over the remainder of 2022 and is why we strongly believe that higher interest rates are a near inevitability. You need to help protect your investors from this contagion. And we believe this needs to happen now, while the market gods have given you a wholly unexpected opportunity to do so at a much-reduced cost.
In this effort, ETFs of the kind my company provides, which provide a targeted negative duration of 10 years and which are designed to increase in value in medium-term interest rates, may prove helpful. There are other products and strategies you may wish to explore as well, including swapping floating for fixed rate bonds, and where appropriate, considering options, although that can be more complex to manage.
We say advisors should move now while the trade is “on sale” to reduce interest rate risk ahead of the Fed’s upcoming all-out war on inflation. It’s only a matter of time before it rejoins the fight.
