Interest rate normalization could spawn a severe bear market
Looking at an investment’s past performance is a frequently used method to predict how it will perform in the future.
It seems like common sense, but you must take care to ensure that you use the right length/duration when it comes to the data set used. It’s also important to understand the bias that data set creates.
Let’s consider historical bond returns and interest rate normalization as an example.
Take the last 35 years of bond performance – a quick glance shows massive declines in interest rate bias, and it should be evident that any predictions made based on that data set will be skewed badly.
Interest rate hikes began to take serious effect starting in the late 1960s. There were several reasons for this, including the consumer spending that led to the baby boom, the effects of the war in Vietnam. It’s also important to remember the oil embargo of 73-74, which jacked up energy prices by a full 400% over the course of just two years.
The result was massive inflation in the US. The Chairman of the Federal Reserve was forced to impose interest rates that were high enough to suffocate inflation.
The problem was that this hike also stalled economic growth, at least for a short while.
The Return to Interest Rate Normalization
The entire point of the Fed’s decision to raise interest rates was to force change – they sought to return everything to “normal.”
However, interest rate normalization did not move as quickly as they expected. In fact, it took the larger part of 35 years.
We’re actually not done with the process yet. It will take a full 50 years to complete (you can expect to see interest rate normalization by 2025). Based on that, it’s logical to wonder if investors have been suckered by the rate bias, creating a bear market that was not foreseen.
Take the Barclays Aggregate Bond Index as an example. If you consider a total return basis, the index has only experienced three years in which it posted negative returns (1994, 1999 and 2013).
That seems like a pretty safe investment, doesn’t it? You’d think you could invest here and never have to worry that you’ll lose a chunk of change. The problem is that this perception isn’t the truth.
The reason is that the index didn’t exist at the start of the cycle, so using this data set doesn’t provide the full story.The truth is that there were rate declines. The high bond coupons due to increased rates by the Fed hid downward price movements.
This fact is setting investors, and particularly retirees and those who plan on retiring soon, up for a big shock.
Let’s suppose a 10-year Treasure dropped by 10% within a year with a coupon of 8%. The loss would be only 2%. Today, the annual return on a bond is under 2.5%, which means that decline would result in a negative return (-7.5%).
Above, you can see 100 years of 10-year Treasury return history. It really shows just how different interest rate normalization is, and what the future might look like. Based on the chart, you can see that for the majority of that 100-year cycle, the rate was between 2% and 5%.
Take Size into Consideration
The amount of government debt needs to be factored into the equation.
Today, our debt is higher than it was at the end of World War II ($19.98 trillion versus $251 billion). While the percentage of GDP is similar then and now, the problem is that if bondholders decide to sell at one time. Consider the charts below.
They illustrate the mounting pressure for holders to sell bonds as interest rates rise (interest rate normalization):
Considering the fact that almost all bond returns were derived from the beginning interest rate of the bond, it’s natural to question what a reasonable return on investment might be if a 10-year Treasury is under 2.5%.
What happens when rates go up? Investors lose.
Look at this charts: 10-year Treasury Notes have lost 7% since summer 2016.
Know How to Calculate Your Bond Losses
If you’re investing in many types of bonds (corporate bonds not included), then you need to ensure that you can calculate your losses.
You can do this by multiplying the duration of the bond by the rate increase. The result is the amount of money you can expect to lose.
For instance, a 10-year duration U.S.Treasury bond will lose 20% of its price if interest rates rise 2% in a year. With a current coupon under 2.5%, the annual total return would be -17.5%! Obviously, there’s the potential for interest rate normalization to create a bear market.
Steps to Take to Mitigate the Effects of Interest Rate Normalization
What’s the answer to the challenge posed by reduced returns on bonds?
Are bonds to be avoided?