A Curvy Yield Curve
October 7th, 2013
A Curvy Yield Curve
Author: Benjamin Struck President
1
Economic Summary
3
Strategic Allocation
5
Tactical Allocation
6
2
Last week the markets were surprisingly calm given the government shutdown. It seems that investors have grown increasingly comfortable with the ongoing brinkmanship that continues in Washington. However, despite the relative calmness in the stock market there were some interesting movements in treasury bills that mature this month. If you look at the first chart on the right you can see that 1month T-bill rates are about the same as a 1 year rates. Usually investors will want to receive higher amounts of interest for longer dated treasuries. This week we will examine some of the basics of the yield curve and how it impacts other investments.
Weekly Changes S&P 500 Index +13.83
+0.82%
Dow Jones Industrial Average -26.36
-0.17%
NASDAQ Composite +71.2
+1.91%
A Quick Review Let’s quickly review how bonds are priced. U.S. Government bonds are issued at $100 a piece. Let’s assume that you wanted to buy a new 10 year note: You would pay $100 and you would in return receive a 2.66% annual return for the next 10 years. Now let’s say that you want to sell your bonds after 5 years. You are now basically selling a 5 year note with the interest rate of a 10 year note (assuming interest rates stayed the same). Currently the rate on a new 5 year note is only 1.41%, but you are still receiving 2.66% so to adjust for this discrepancy your bond will be worth more than the original $100 that you paid for it. It is also important to remember that rising rates are negative for bond prices and vice versa, because if you buy a new 5 year bond that pays 1.41% and the next day interest rates go up, your 1.41% bond is less valuable than new bonds with higher interest rates. Yield Curves I want to discuss three types of yield curves: Normal, flat and inverted. Most of the time the yield curve is normal and it resembles a logarithmic curve. A normal yield curve
has been the most common type of yield curve since the great depression. This is because the Federal Reserve has a set inflation target so investors expect that a dollar today will be worth more than a dollar tomorrow. This means that investors will usually demand a higher return to hold an investment for a longer period of time. 3
Flat Curve
A flat yield curve is usually a sign of uncertainty about future rates. In reality, the yield curve is never perfectly flat like you see on the right. A flat curve might occur during a time when investors are expecting some deflation due to a recession.
The Dreaded Inverted Curve An inverted yield curve would be Ben Bernanke’s biggest fear. An inverted yield curve would imply that investors were expecting rapid deflation. Inverted yield curves have been uncommon since the creation of the Federal Reserve. An inverted yield curve is an extremely accurate predictor of recessions, in fact an inverted yield curve is probably the best indicator because it also avoids false positives. For example, there was no yield curve inversion during the crash of 1987 and despite the stock market crash the economy never entered a recession. Is the Yield Curve Inverting? It might seem like the yield curve is inverting, but this time it is happening because of political risk. The current yield curve looks normal with the exception of 1 month treasury bills. This is obviously related to the debt ceiling debate and investors should expect short term rates to rise as we approach the debt ceiling. In the event of a resolution these rates will fall dramatically and a normal yield curve will likely be restored. Conclusion An interesting trade that has risen out of this is to buy short term treasury bills for a higher yield and to sell short longer term treasuries. There are probably many hedge funds using massive leverage to profit from this trade. In the
event of a default. These hypothetical hedge funds will take massive losses which will add a huge amount of risk to the economy during the worst possible time. In 1998, a major hedge fund name Long Term Capital Management, bet on Russian debt, drawing the false conclusion that nuclear powers don’t default on their debt. Despite claims to the contrary and its ability to make payments, Russia defaulted and completely wiped out Long Term Capital Management. The collapse of Long Term caused massive systemic risk which required a Federal Reserve organized bailout, the first of its kind. There is no precedent for a U.S. government default and the risks are unknown. However, investors should beware similar claims that doomed Russian investors in 1998 and exercise caution and prudent diversification. 4
*https://faculty.fuqua.duke.edu/~charvey/Term_structure/Harvey.pdf
Strategic Allocation Conserva-
Aggressive
RISK SCORE
1
2
3
4
5
6
7
8
9
10
Debt Short Term intermediate term long term floating
66 28 20 9 9
54 21 21 7 5
48 19 20 7 2
40 16 15 7 2
33 14 13 4 2
27 10 11 4 2
19 7 7 4 1
15 5 5 4 1
8 3 3 2 0
8 3 3 2 0
Equities small cap mid cap large cap
18 3 3 12
27 4 5 18
33 8 9 16
41 8 14 19
47 13 14 20
51 14 17 20
59 17 23 19
64 21 24 19
71 27 26 18
71 32 28 11
Other Reits Commodities currency
16 8 5 3
19 10 6 3
19 10 6 3
19 10 6 3
20 10 7 3
22 11 8 3
22 11 8 3
21 10 8 3
21 9 9 3
21 8 10 3
total
100
100
100
100
100
100
100
100
100
100
The Strategic allocation represents what should be the long term average of a portfolio. That is, the average allocation of the portfolio should adhere to these risk allocations. Different asset classes will outperform during different market conditions. This allocation will change slowly as new information comes to light that will affect the long term performance of certain asset classes. We expect that portfolios that are more aggressive will outperform conservative portfolios over a longer period of time, but will experience a greater amount of volatility.
5
Overweight short term debt, par ticular ly for mor e conser vative clients. This sector should r educe interest rate risk as well as market risk in the portfolio.
Neutral intermediate term debt
Neutral Long Term Debt, Long ter m debt has substantial r isk if inter est r ates r ise, but can still help alleviate losses in the event of a rapid stock market selloff. This asset class has been oversold and we are using closed-end funds that are trading at a discount to net asset value to participate.
Overweight on floating rate debt, we ar e expecting slow and steady appr eciation on floating rate notes.
Small Capitalization Stocks, we ar e r ecommending a neutr al holding of smaller companies with str ong balance sheets and little need for short term debt financing.
Neutral Mid-Cap Stocks, we apply the same logic to this asset class as to small cap stocks.
Neutral Large Cap Stocks, We ar e mor e selective with lar ge cap stocks, if signs of inflation pick up we will look to invest in large cap companies with high debt. We are extremely bearish on tech companies with stretched earnings multiples.
Neutral REITs,
Neutral Commodities,
Currency - We are underweight the Euro. We continue to recommend protecting any exposure to the yen. We are currently holding higher levels of cash generally.
6
A Curvy Yield Curve
Author: Benjamin Struck President
1
Economic Summary
3
Strategic Allocation
5
Tactical Allocation
6
2
Last week the markets were surprisingly calm given the government shutdown. It seems that investors have grown increasingly comfortable with the ongoing brinkmanship that continues in Washington. However, despite the relative calmness in the stock market there were some interesting movements in treasury bills that mature this month. If you look at the first chart on the right you can see that 1month T-bill rates are about the same as a 1 year rates. Usually investors will want to receive higher amounts of interest for longer dated treasuries. This week we will examine some of the basics of the yield curve and how it impacts other investments.
Weekly Changes S&P 500 Index +13.83
+0.82%
Dow Jones Industrial Average -26.36
-0.17%
NASDAQ Composite +71.2
+1.91%
A Quick Review Let’s quickly review how bonds are priced. U.S. Government bonds are issued at $100 a piece. Let’s assume that you wanted to buy a new 10 year note: You would pay $100 and you would in return receive a 2.66% annual return for the next 10 years. Now let’s say that you want to sell your bonds after 5 years. You are now basically selling a 5 year note with the interest rate of a 10 year note (assuming interest rates stayed the same). Currently the rate on a new 5 year note is only 1.41%, but you are still receiving 2.66% so to adjust for this discrepancy your bond will be worth more than the original $100 that you paid for it. It is also important to remember that rising rates are negative for bond prices and vice versa, because if you buy a new 5 year bond that pays 1.41% and the next day interest rates go up, your 1.41% bond is less valuable than new bonds with higher interest rates. Yield Curves I want to discuss three types of yield curves: Normal, flat and inverted. Most of the time the yield curve is normal and it resembles a logarithmic curve. A normal yield curve
has been the most common type of yield curve since the great depression. This is because the Federal Reserve has a set inflation target so investors expect that a dollar today will be worth more than a dollar tomorrow. This means that investors will usually demand a higher return to hold an investment for a longer period of time. 3
Flat Curve
A flat yield curve is usually a sign of uncertainty about future rates. In reality, the yield curve is never perfectly flat like you see on the right. A flat curve might occur during a time when investors are expecting some deflation due to a recession.
The Dreaded Inverted Curve An inverted yield curve would be Ben Bernanke’s biggest fear. An inverted yield curve would imply that investors were expecting rapid deflation. Inverted yield curves have been uncommon since the creation of the Federal Reserve. An inverted yield curve is an extremely accurate predictor of recessions, in fact an inverted yield curve is probably the best indicator because it also avoids false positives. For example, there was no yield curve inversion during the crash of 1987 and despite the stock market crash the economy never entered a recession. Is the Yield Curve Inverting? It might seem like the yield curve is inverting, but this time it is happening because of political risk. The current yield curve looks normal with the exception of 1 month treasury bills. This is obviously related to the debt ceiling debate and investors should expect short term rates to rise as we approach the debt ceiling. In the event of a resolution these rates will fall dramatically and a normal yield curve will likely be restored. Conclusion An interesting trade that has risen out of this is to buy short term treasury bills for a higher yield and to sell short longer term treasuries. There are probably many hedge funds using massive leverage to profit from this trade. In the
event of a default. These hypothetical hedge funds will take massive losses which will add a huge amount of risk to the economy during the worst possible time. In 1998, a major hedge fund name Long Term Capital Management, bet on Russian debt, drawing the false conclusion that nuclear powers don’t default on their debt. Despite claims to the contrary and its ability to make payments, Russia defaulted and completely wiped out Long Term Capital Management. The collapse of Long Term caused massive systemic risk which required a Federal Reserve organized bailout, the first of its kind. There is no precedent for a U.S. government default and the risks are unknown. However, investors should beware similar claims that doomed Russian investors in 1998 and exercise caution and prudent diversification. 4
*https://faculty.fuqua.duke.edu/~charvey/Term_structure/Harvey.pdf
Strategic Allocation Conserva-
Aggressive
RISK SCORE
1
2
3
4
5
6
7
8
9
10
Debt Short Term intermediate term long term floating
66 28 20 9 9
54 21 21 7 5
48 19 20 7 2
40 16 15 7 2
33 14 13 4 2
27 10 11 4 2
19 7 7 4 1
15 5 5 4 1
8 3 3 2 0
8 3 3 2 0
Equities small cap mid cap large cap
18 3 3 12
27 4 5 18
33 8 9 16
41 8 14 19
47 13 14 20
51 14 17 20
59 17 23 19
64 21 24 19
71 27 26 18
71 32 28 11
Other Reits Commodities currency
16 8 5 3
19 10 6 3
19 10 6 3
19 10 6 3
20 10 7 3
22 11 8 3
22 11 8 3
21 10 8 3
21 9 9 3
21 8 10 3
total
100
100
100
100
100
100
100
100
100
100
The Strategic allocation represents what should be the long term average of a portfolio. That is, the average allocation of the portfolio should adhere to these risk allocations. Different asset classes will outperform during different market conditions. This allocation will change slowly as new information comes to light that will affect the long term performance of certain asset classes. We expect that portfolios that are more aggressive will outperform conservative portfolios over a longer period of time, but will experience a greater amount of volatility.
5
Overweight short term debt, par ticular ly for mor e conser vative clients. This sector should r educe interest rate risk as well as market risk in the portfolio.
Neutral intermediate term debt
Neutral Long Term Debt, Long ter m debt has substantial r isk if inter est r ates r ise, but can still help alleviate losses in the event of a rapid stock market selloff. This asset class has been oversold and we are using closed-end funds that are trading at a discount to net asset value to participate.
Overweight on floating rate debt, we ar e expecting slow and steady appr eciation on floating rate notes.
Small Capitalization Stocks, we ar e r ecommending a neutr al holding of smaller companies with str ong balance sheets and little need for short term debt financing.
Neutral Mid-Cap Stocks, we apply the same logic to this asset class as to small cap stocks.
Neutral Large Cap Stocks, We ar e mor e selective with lar ge cap stocks, if signs of inflation pick up we will look to invest in large cap companies with high debt. We are extremely bearish on tech companies with stretched earnings multiples.
Neutral REITs,
Neutral Commodities,
Currency - We are underweight the Euro. We continue to recommend protecting any exposure to the yen. We are currently holding higher levels of cash generally.
6
