Category: Inflation


The Bright Side of Rising Rates

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Content provided by Grant Engelbart, CFA, CAIA, CLS Portfolio Manager

Investors have been infatuated with the timing and pace of the Federal Reserve’s (Fed’s) plan to raise interest rates ever since rates were pinned at the zero bound in the midst of the financial crisis. Most of the rhetoric regarding interest rate hikes is negative, after all, who wants to “pay more” for money? These fears for financial assets are overblown, as we have mentioned before. Besides focusing on the negatives, what are some of the benefits of higher interest rates?


Remember when your bank account paid you interest? Slowly but surely, banks are starting to raise the amount they pay customers. Online savings accounts typically have a slower process for moving funds, but those who are willing to accept a little less liquidity can get around 1% in interest. The craziness of celebrating 1% interest aside, it isn’t easy to find products paying 1% with a government guarantee (FDIC insurance) and no principal fluctuation.


Most fears regarding rising interest rates are based on client’s bond holdings (which nearly all investors have, whether they know it or not). We have written extensively on how important bonds are to portfolios and why investors definitely should not abandon them. When investing in bonds – whether through ETFs, mutual funds, or direct bond ownership –there are interest payments and bond maturities that need to be reinvested. Reinvesting these at higher interest rates is beneficial, particularly as the starting interest rate on a bond is often the best predictor of its return.


Interest rates rarely rise in a sustainable way without a prior rise in inflation. The word inflation typically brings memories of the 1980s or stories about the Weimar Republic to mind; however, moderate inflation is typically a sign of a healthy economy. By definition, inflation implies rising prices and wages. The latest jobs report shows wages rising nearly 3% from December 2015 to December 2016, which is currently faster than CPI inflation in the U.S.


Investment vehicles that use derivatives, such as futures contracts, have to collateralize their exposure. This collateral is typically invested in short-term, safe instruments, such as T-bills. Rising interest rates benefit the collateral yield of a futures position. This is particularly beneficial to commodity investments through ETFs, which typically use futures contracts to gain that exposure. Not to mention, commodities are also a hedge against inflation, which as mentioned accompanies rising interest rates.

Interest rates are an integral part of an economic system that affect nearly everyone. Borrowing money at higher interest rates is not preferable, however, the slow expected rise in rates doesn’t have to be detrimental and can actually benefit segments of the economy and population.



The September FOMC Meeting

Financial charts abstract business graph and exchange rates 3d background

Financial charts abstract business graph and exchange rates 3d background

Content provided by Josh Jenkins, CFA, CLS Portfolio Manager

Why a Hike Here Should Not Matter to Long-Term Investors

The financial media has been focused on whether or not the Federal Open Market Committee (FOMC) will move to increase interest rates this week. Does this mean that long term investors should also take notice? Does an additional 0.25% hike represent a shift in monetary policy? And should this affect the long term outlook for the bond market?

The chart below provides some historical context to the scale of the potential move. The federal funds rate, the benchmark rate that has been used to control monetary policy, is currently being managed in a range of 0.25% – 0.50%. We can see that even after the Fed increased the level of this benchmark rate last December, it is still considerably below the level found in any other cycle going back to the 1960s. The same will hold true if rates are increased at the September meeting. Since the 1960s, the effective federal funds rate has averaged approximately 5.0% and peaked as high as 19.1%. Clearly, even after another 0.25% increase, monetary policy would be considered extremely accommodative.


Many are fearful about what a hike in September will do to returns in their bond portfolios. If people are panicking about this small move, then surely portfolios must have been obliterated by the seismic shifts that have occurred in the past. Fortunately for us, this has not been the case.

We analyzed returns of intermediate-term government bonds going all the way back to the 1920s. What we found is the performance of bonds over longer-term horizons has been truly impressive. The annualized return over any three-year period has been positive more than 99% of the time. In the few instances it has been negative, losses were hardly devastating at just -0.2% on average. Performance was even more impressive on a rolling five-year basis, where they were positive 100% of the time with an average gain of 5.4%. Is also interesting to note that bonds have outperformed the stock market since the Fed increased rates last December.



Ultimately, the Fed’s decision at the September meeting should have no impact on the long-term investor. A move here would not represent a large shift in monetary policy. Even if it did, history has shown us that the bond market has an overwhelming tendency to be positive. So tune out the noise, stay disciplined, and stick to your long-term plan.



Inside Capstone: Rising Interest Rates

Capstone’s Director of Fixed Income Investments and Portfolio Manager, Victoria Fernandez talks with CLS’s Portfolio Manager, Josh Jenkins, CFA, about whether or not investors should be concerned with the risining interest rates.


Likelihood of Interest Rate Hikes and Their Effect on Your Portfolio

interest rates

Content provided by Josh Jenkins, CFA, CLS Portfolio Manager

Recent guidance from the Federal Reserve (Fed) suggests it may finally be ready to lift interest rates at its next meeting on December 16, and the market has taken note.

According to Bloomberg, as of December 10 the probability of a hike was 80%. Bloomberg has a cool function that calculates the probability of a rate hike at any given Federal Open Market Committee (FOMC) meeting based on the pricing of certain derivative contracts. This function is illustrated below and has frequently been quoted in the financial media.


In addition to determining the probability of a rate move at any given meeting, the function also determines the probability of interest rates falling within a particular range. The table below illustrates this probability distribution for interest rates in December 2016. This distribution implies that the benchmark rate will be at 0.86% in 12 months. Given the benchmark rate is currently between 0.00% and 0.25% (we can assume the middle point of 0.125% for simplicity), pricing in these derivative contracts implies three rate hikes over the next 12 months.

Here’s the formula:

(Interest rate in 12 months – current interest rate) / size of each rate hike

(0.86-0.125)/0.25 = 3


Three rate hikes in the next 12 months!? We should sell all our bonds right!? Wrong. Three rate increases in 12 months can be considered a slow and steady pace, and there are several reasons to believe this slow pace will not cause interest rates to rise on the long end of the curve:

  • Conflicting economic and inflation data
  • Nominal growth is expected to remain low
  • Global interest rates are low
  • Potential equity market weakness

So what could bond portfolio returns look like in this scenario (rates increase on the short end but not the long end)? Below is a simplified analysis to illustrate:


The table above breaks down the components of total return for the Aggregate Bond Index (a proxy for the domestic bond market). The return components include price return and yield. From this we can see the rise in interest rates reduces the value of the bonds (price return), but the coupon payments (yield) are more than able to cover the loss. To emphasize: in this scenario there will likely be some initial volatility, but the return on fixed income can still be positive, even with a rate hike.

This simplified analysis ignores the effects of a potential increase in default rates (this would lower expected bond returns), the effects of the roll yield (this would increase expected bond returns), and convexity.


The views expressed herein are exclusively those of CLS Investments, LLC, and are not meant as investment advice and are subject to change.  No part of this report may be reproduced in any manner without the express written permission of CLS Investments, LLC.  Information contained herein is derived from sources we believe to be reliable, however, we do not represent that this information is complete or accurate and it should not be relied upon as such.  All opinions expressed herein are subject to change without notice.  This information is prepared for general information only.  It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report.  You should seek financial advice regarding the appropriateness of investing in any security or investment strategy discussed or recommended in this report and should understand that statements regarding future prospects may not be realized.  You should note that security values may fluctuate and that each security’s price or value may rise or fall.  Accordingly, investors may receive back less than originally invested.  Past performance is not a guide to future performance.  Investing in any security involves certain systematic risks including, but not limited to, market risk, interest-rate risk, inflation risk, and event risk.  These risks are in addition to any unsystematic risks associated with particular investment styles or strategies. The graphs and charts contained in this work are for informational purposes only.  No graph or chart should be regarded as a guide to investing.

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