Higher Interest Rates for Longer (and What to do about it)

We see some storm clouds gathering as “higher for longer” interest rate era plays out. Over the past 3 months, we have had an enormous selloff in long term fixed income. Basically, the bond market is saying: “we don’t know if inflation is under control, and we don’t know if rates will move higher.” And also: “the US government is spending too much.”

The anxiety in markets is good work by the Fed. If the Fed were to signal that we are at peak interest rates and the next move in rates was down, the stock market would be too hot and so would the bond market.

What is the Fed trying to accomplish?

• They are trying to knock back home prices, which are not affordable.

• They are trying to slow down consumption and investment by raising rates.

• They are also trying to put a little bit of slack in the labor market. (The recent negotiations between UPS and its union and the UAW strike are illustrations of how the tight labor market perpetuates inflation.)

Investment prices are also a factor: people generally spend less when they feel less rich. The Fed, in order to fight inflation, wants people to feel less rich. They will probably not back off of higher rates until asset prices– including stocks– come down a bit.

Actually, prices on bonds and quite a number of stocks have come down a bit. On 10/2, about 80% of the stocks in the S&P 500 were down for the day. However, the index held up because the big cap tech companies went up. The index performance is obscuring the information that the average stock is not up very much or at all this year.

Real estate markets take longer to move. Ironically, the last era of financing with 3% mortgages is still having a tailwind effect on home prices: People with 3% mortgages are less inclined to sell their homes and buy one with a 7% mortgage. This is keeping supply off the market, meaning that the homes that are for sale are competing with fewer homes for sale. This is supporting high pricing—on a thinner and thinner stock of homes, and at higher and higher interest rates. This provides opportunity for national homebuilders to add supply. 

But the endgame is that the tailwind will go away. Prices should come down at some point, and they are starting to come down. The past 3 year move in home prices is unsustainable- and undesirable; affordable housing is an important input to a healthy economy. You can judge “affordable” by how much money you’d need to earn to live in that house.

Jeffrey Gundlach (bond manager) at the Future Proof investment conference made the point that to afford the average home in the country, (at about $400,000) you’d need to earn about $190,000 per year.  That’s not *exactly right, but close enough. Yikes. That sounds unsustainable. 

Buying Bonds

We are buyers of high quality bonds. Treasuries, municipals, corporates. Investment grade or better. We are adding “duration.” After years of avoiding interest rate sensitivity, we are buying it.  We want to buy the assets that have been most negatively impacted by the rise in interest rates. The logic extends to electric utility stocks and some REITs. Basically, most investments that pay out dividends or interest have been hurt in the rising rate environment.

We are betting that next year won’t look like this year. This year, we called soft landing. Ok, so far so good.

Next year? Probably a slowdown, maybe a recession. We see higher interest rates catching up, starting right now.

The Downside Risks of Bonds

The risks of being wrong on this count are not that terrible. For instance, if you bought the 10 yr. US treasury bond, the yield today is 4.73% (Koyfin 10/6) , about the highest it’s been since 2007. And by the way, if you bought that bond and held it to maturity, you know exactly what to expect: you would get 4.78% over the 10 year life of the bond.

Even if bond prices went further down in 2024, you would expect a *higher rate of return on your bonds in future years. It’s just a matter of time until you get the return if the credit is good. For instance, if interest rates went up from 5% to 6%, your bond price would go down so that your future expected return would now be 6% per year instead of 5%.

In other words, continuing to hold the bond you bought at 5% interest would be an obvious choice, even though you’d wish you had gotten lucky enough to do all your buying at the very bottom price. But this is not how things work in the real world: you don’t know the bottom price, and you can stop trying. 

If we are wrong in 2024 and rates rise another 1%, we will just about break even on the 10 year treasury bond in one year or be down 1% (the price might go down 6%, while we earn almost 5% in interest). 

Now, that is not as good as being up 5% on your money market account in that case. But it is also not a disaster. 

This is a good illustration of how different time frames affect those investment decisions. If you are hoping to buy a house before October of next year, a 5% money market account is probably the best decision. You need the money, and you’ll know what to expect. We will help you hold that short term money without charging you for it. Why take more risk?

What if you don’t need the money for 2 years? It’s hard to know whether the money market account or the longer term bond will outperform. I think money market rates will be lower in 2 years. The risks aren’t bad in either case. We expect you’d have a positive return on both investments over 2 years. 

But over 3 years or longer? 

I think the odds are skewed towards long term debt outperforming short term money, and investors ought to gradually shift money from money markets to long term bonds. If you have 2-3 years to play with, this will probably work out, and maybe even sooner than that. 

The Upside Potential for Longer Bonds

But what if we are already at or near peak rates? If rates fall 1% from current levels, on the 10 yr. treasury bond, you would collect about 6% in price appreciation plus about 5% in interest.

So, we can *estimate that the downside risk on the 10 yr. treasury bond over the next 12 months is about -1%, while the upside potential is perhaps 11%.

This is what investing is all about: trying to find risk and reward tradeoffs we like and can live with, even if it doesn’t go exactly as expected. Because often, it doesn’t go as anyone expected.

What would we do if we were wrong? Say we pushed 20% of a portfolio to longer term fixed income. And rates rose. Oh no! It’s not a big deal, we’d buy more bonds, at close to a 6% interest rate. Maybe we’d push long term bonds from 20% to 30% of the portfolio: we might add 50% to the size of the position.

This is likely to work out at some point, even if it’s not in 2024. As soon as rates turn, the position we bought over 12 or 18 months is likely to look pretty good.

We are agnostic about whether that happens in 2024 or later; those are not things you get to know at this point. Forecasting has been a fools’ errand since covid. We are not betting we are right. We are betting the risk/reward is good enough.

Scale Buying

Should you buy your whole position today? No. There is a lot of treasury issuance because the government is doing a lot of deficit spending. That’s creating an oversupply in the market, pushing prices down and yields higher.

But is this a good point of entry? I think it is. This is about the biggest rout we’ve seen in long bonds in 15-20 years.

• You should strategize to make several purchases, especially in the case long term rates go higher. Think about the prospect of the 10 year treasury yield going to 6%. Will it? Who knows. Probably not, in my opinion. But if it does, what’s your game plan? I think you’d like to be able to buy here and several times again if prices are lower.

• Buying exchange traded funds that hold bonds is one way to quickly adjust your allocation to long term bonds. You can simply add to your position if prices fall.

Up until recently, bonds have not diversified your risk from stocks. They’ve both moved down together far too often in response to rising rates. The recent correlation between stocks and high quality bonds hit 50%. This is not likely to be the case after rates stop rising. We will probably get true diversification from stocks out of fixed income in the future.

Most investment managers are focused on quarterly and one-year returns because they need to justify their jobs by outperformance against an index. We are not looking at wealth that way. We are trying to help our clients build sensible positions for the real world. 

Not everything that is a good choice plays out this week or this quarter. Having a slightly longer view allows our clients to approach the market strategically rather than reacting negatively to unexpected changes.

Indeed, this is life. We can’t change the nature of things, but we can make what is happening a lot more fun to experience. We can orient ourselves to risk as opportunity. We can have a good time navigating change with people we like and trust.