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Don't Believe the Conventional Wisdom When It Comes to Rising Interest Rates

Oct 30, 2017


Investors have been waiting years for interest rates in the U.S. to rise.

In recent years, murmurings by the Federal Reserve, the American central bank, about interest rates have been enough to send markets into a tailspin.

And conventional wisdom says an interest rates rise is bad for stocks - especially "risky" ones like emerging market stocks.

But the truth might surprise you...

Rates aren't going to go back to a "normal" level anytime soon

For starters, though, I don't think we're going to have to worry about rates rising anytime soon. As Tama wrote a few months ago, the chances are slim that interest rates will rise much over the next few years.

Over the past 40 years, the Fed funds rate (which is the weighted average interest rate at which banks lend each other funds held at the Federal Reserve) has averaged 5.3 percent. Over 30 years, the average is 3.65 percent. So the current level (of 1.25 percent) is well below the historic average...

Take a look at the chart below. It shows the market-implied future Fed funds rate from today, to three years in the future. These rates are what the market currently predicts the Fed funds rates will be in the future.

The market is telling you that three years from today, the implied Fed target rate will only be 1.70 percent.

The current upper bound is 1.25 percent. So that means the market is only expecting a further 0.45 percent rate hike from the Fed in the next three years (i.e., from 1.25 percent to 1.70 percent).

implied Fed Rate

Investors think that rates aren't going to rise much at all over the next three years. But what happens when  - at some point - they finally do? Will there be a mass exodus out of stocks and into safer assets?

Here's how assets perform in a rising rate environment

It's a common belief that rising interest rates are bad for "riskier" assets like emerging market stocks.

But take a look at the chart below...

This shows the total average return of different assets in a rising interest rate environment from 1994 to 2017. Returns were counted if the 10-year yield rose more than 0.25 percent over a three-month period, and the chart above shows the annualised average returns of each asset class.

And as you can see, "riskier" assets actually outperformed during this time.

High dividend emerging market equities returned an average of 8.6 percent... Emerging market equities returned 8.1 percent... High-dividend Asia Pacific ex Japan equities returned 6.7 percent... and Asia Pacific ex Japan equities returned 6.6 percent. Meanwhile, Asia Pacific equities returned 5.7 percent... and developed market equities returned 4.7 percent.

Meanwhile, "safer" debt assets underperformed. High-yield U.S. equities returned just 2.4 percent... emerging market debt returned just 1.1 percent... and U.S. Treasuries actually lost 3.5 percent of their value.

So in this case, the conventional wisdom has been wrong.

And the truth is, U.S. Treasuries can be just as risky as emerging market stocks

Emerging market stocks are widely thought to be one of the most volatile asset classes you can own. And, conversely, "risk-free" U.S. Treasuries are viewed as the safest asset. But that's not always the case, because for Treasuries, you have to take interest rate risk into account...

The duration of your bond portfolio is a key determinant of how much risk you're exposed to.

Duration tells you how long it will take for the interest payments generated to repay the invested principal. Duration will indicate the approximate change in price of a bond for a given change in interest rates.

For example, if a bond's duration is five years and interest rates rise by one percent, the price of the bond falls by approximately five percent (and vice versa).

The duration of, say, the iShares 7-10 Year Treasury Bond ETF (New York Stock Exchange; ticker: IEF) is around 7.5 years.

And the duration of the Vanguard Extended Duration Treasury ETF (New York Stock Exchange; ticker: EDV) is 24.5.

Those are just two examples. But as a general rule, for every 1 percent move in interest rates, you can expect roughly a 25 percent price move in your ETF. That's why a portfolio of U.S. Treasuries can be just as risky as emerging market stocks.

So what should you do?

For starters, don't sell if you think interest rates will eventually rise. The best way to profit during times of low or rising interest rates is to be diversified. And as the graphs above show, interest rates won't rise materially for a while... and when they do, the assets that conventional wisdom suggests will underperform actually probably won't do so poorly at all.

Please note: This article was first published in Stansberry Churchouse Research on 26 October, 2017.

Kim Iskyan is the founder of Singapore-based Truewealth Publishing. He has spent most of the past 25 years exploring and analyzing global markets. He has been a stock analyst and research director for a big emerging market investment bank, managed a hedge fund, and sold mutual funds to private bankers. He has advised Fortune 50 companies on political risk and helped build stock exchanges from scratch in countries that few people could find on a map. He has lived and worked in ten countries, from Spain to Russia to Sri Lanka to the United States.

Disclaimer: The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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1 Responses to "Don't Believe the Conventional Wisdom When It Comes to Rising Interest Rates"

Suresh Nair

Nov 2, 2017

I agree with the views provided above and there is a general consensus that rates are on the rise but the trajectory will be flatter rather than a steeper one. World economy seems to be in a recovery mode, BOE has just raised its interest rate, Powell will be the new Fed chairman....there are so many moving parts, but assuming only a gradual increase in interest rate is a safe bet.

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