October 30, 2017: Rising Interest Rates

Oct 31, 2017 | Asset-Allocation, Bonds, Economy, Feature, Gold, Headline, Income, Investments, IRA, Markets, Mutual-Funds, Newsletter, Retirement

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As a reminder to expert users: advanced portfolios are still re-balanced based on their original re-balance schedules and they are not the same as those used in Strategic and Tactical Asset Allocation (SAA and TAA) portfolios of a plan.

Please note that we now list the next re-balance date on every portfolio page.

Rising Interest Rates

Recently, there have been some volatility in fixed income market. Some of key events include

  • The upcoming Federal Open Market Committee (FOMC) meeting this week
  • President Trump will likely announce his pick for the next Federal Reserve’s chairman. 

Bond interest rates have risen in general. Let’s first review some key segments. 

Long term interest rate, high yield bonds and international bonds

In general, long term Treasury interest rate is one of the key factors to watch regarding the health of the current bull market in bonds. The following shows the chart of 10 Treasury interest rate:

Bond experts like Jeffrey Gundlach and Bill Gross have indicated that 2.4% is a key level to watch. In fact, both have said breaching this level in some extended period would signal the end of the long term (30 years or so) bond bull market. At this moment, we don’t know whether this rise is again a short term blip or can extend in a longer period. 

In addition to long term interest rates, we also watch high yield bonds closely. The behavior of these bonds are more sensitive to so called credit risk — a way to gauge the general health of the current economy. The following chart shows the chart of SPDR High Yield Bond ETF JNK: 

So high yield bond market barely budged. Coupled with the near record stock market level, one can only conclude that investors are still very optimistic about the current economy. 

In addition to the above two key bond areas, another segment worth watching is the international bonds and emerging market bonds. Because of the anticipation of rising rates, U.S. dollar has risen and that in turn pushed down the foreign bonds. The following is the table of our bond trend scores:

Currently, intermediate Treasury and long term Treasury bonds, as well as international bonds are showing negative trend scores. TIPs (inflation protected bonds) are also showing negative scores, indicating markets don’t expect higher inflation ahead. 

Federal Reserve chairman candidates

Trump has indicated that he’s leaning to select Jerome Powell as the next Federal Reserve Chairman. Powell is the one who has shown to be very much in favor of current loose monetary policy. Another candidate, John Taylor, is famous for his Taylor’s rule that links unemployment rate to inflation. He is considered to be more hawkish and most likely to raise rates more dramatically if he’s leading the Fed.

Markets are uncertain about the two very different candidates. This has added to the volatility in the recent bond market. 

What to do

As always, we claim that we have no crystal ball on the near term markets. In fact, as shown in history, we claim that no one has such a power. So it’s no use to forecast/predict what’s next in the near term.

However, we do believe that the big picture can help us to position our portfolios better, especially in terms of managing risk. In general, we believe the current interest rate has been historically low for sometime and it will eventually rise to a more normal level. In such a rising rate environment, the returns from ‘safe’ fixed income will become more problematic. In fact, many have predicted negative returns: GMO, for example, forecast that US bonds will return -0.8% annually in the next 7 years. 

We believe that the current bond environment calls for a more active investing strategy. Our long held belief is that in fixed income markets, a tactical or dynamic bond segment rotation based on their trends can help to reduce risk and in fact, dramatically improve returns. See, for example, our analysis in Asset Class Primer. 

One of the effective ways to avoid risk and generate better returns is to rotate among total return bond funds that are actively managed by some of the best bond managers. These portfolios select only one such a fund to invest monthly. In some extreme case when interest rates rise dramatically, the portfolios can hold cash instead.  For more information on these portfolios, you can read the newsletter June 3, 2013: Total Return Bond Fund Portfolios For Major Brokerages

The following shows the performance of these portfolios that are customized for brokerages. They have consistently outperformed major bond market index funds and even any total return bond fund (listed on What To Do -> Brokerage Investors page):

Latest Fixed Income Bond Fund Portfolios Performance Comparison (as of 10/27/2017)

Ticker/Portfolio Name YTD
Return**		 1Yr AR 3Yr AR 5Yr AR 10Yr AR
Schwab Total Return Bond 6.4% 6.6% 4.0% 4.9% 7.8%
Fidelity Total Return Bond 6.4% 4.9% 2.6% 4.1% 7.1%
TDAmeritrade Total Return Bond 6.0% 3.8% 3.1% 4.4% 7.6%
FolioInvesting Total Return Bond 6.4% 6.6% 4.0% 4.9% 7.8%
Etrade Total Return Bond 6.5% 6.0% 3.9% 4.9% 7.8%
Merrill Edge Total Return Bond 6.4% 4.9% 3.6% 4.7% 9.0%
Vanguard Brokerage Total Return Bond 6.4% 6.6% 4.0% 4.9% 7.9%
PTTRX (PIMCO Total Return Instl) 4.4% 2.5% 2.7% 2.3% 5.4%
VBMFX (Vanguard Total Bond Market Index Inv) 2.5% 0.3% 2.0% 1.8% 4.0%

**YTD: Year to Date

To summarize, current bond market is experiencing another volatile period amid rising rate concerns. We have seen similar behavior several times this year now. Though we can’t and don’t want to predict markets, we do believe a proper review on bond investment strategies is called for. We believe fixed income investors need to adopt a more active strategy in the coming years to cope with a possible bear market or the ending of the current long super bond market. 

Market Overview

The Q3 earnings report is in progress. Last week, more than half (55%) of S&P 500 companies have reported earnings. The result is better than expected: the expected blend earnings so far is 4.7%, better than 3% expected on June 30, 2017. Even though bond markets experienced some turbulence, investors seem to be still open to risk exposure. Risk assets are still rising. As always, we remain cautious in the current overvalued stock and bond environment. Stay the course and manage risk properly. 

For more detailed asset trend scores, please refer to 360° Market Overview. 

Now that the Trump administration has been in the office for more than half a year, it has stumbled and encountered many difficulties to implement its promised changes in terms of tax cuts, job stimulation and infrastructure spending. On the other hand, stocks continued to ascend, regardless of the progress. Looking ahead, however, we remain convinced that markets will experience more volatilities at some point when reality finally sets in. 

In terms of investments, U.S. stock valuation is at a historically high level. It is thus not a good time to take excessive risk. However, we remain optimistic on U.S. economy in the long term and believe much better investment opportunities will arise in the future. 

We again would like to stress for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot. 

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