Read the weekly bond market commentary from Doug Drabik.
March 5, 2018
Getting ahead of the game is what investing is all about… right? Well that can be viewed from very different perspectives. Of course everyone wants to optimize earnings, beat the averages and accumulate maximum wealth. Where the difference lies is our ability to psychologically and objectively deal with the risks associated with reaching these potentials. It is important that investors distinguish between tactical and strategic approaches and that they should not be substituted for each other.
Think of tactical as offensive alignment of money in asset classes poised to beat the averages. Appreciation is expected along with income. These offensive-minded moves may be quick plays, in-and-out of the market and capitalizing on news and knowledge ahead of market changes. It may be a short timed stock play or a longer timed perfectly located piece of real estate. The goal is growth of money.
Think of strategic as defensive alignment of money in asset classes poised to be consistent. Consistent cash flow and income. A known commodity where preservation of wealth is as important as income stream and price appreciation or depreciation is somewhat less important knowing that these assets (individual bonds) can be held to maturity, negating any price movement over the holding period.
So when we hear market breaking news, it is essential to translate that news appropriately to the portfolio and individual investments. For example, hearing breaking news on a new chip that will revolutionize the tech market may create urgency in re-aligning tactically placed assets (i.e. stocks) yet have little bearing on the alignment of strategic assets (individual bonds). Market timing is central for tactical assets and much less significant for strategic assets.
Inflation has surfaced again as a key indicator which is driving volatility in the bond market. Be careful about getting caught up in the market hype. First of all, does it bear significance to your strategic plan? We’ve been through this cycle before when many were convinced inflation was upon us. Investors piled into Treasury Inflation Protected Securities (TIPS) to “protect” themselves from imminent inflation. Some of this protection came at a cost, even negative returns. When inflation never surfaced at the anticipated level, the “protection” became a liability to the portfolio. Many prudent plans prefer strategic assets to be a known commodity, not a prognostication of what might happen. In other words, leaving the speculation to the tactical assets.
Consider that for that last twenty-five years, inflation has remained in a very tight range of roughly 1.00%-2.50% and that period included some chaotic times such as the Dot Com bubble and the Great Recession. The Fed has shown resilience in their ability to manage inflation. The following chart depicts the tight range that inflation has been in:
The Fed appears determined to get ahead of inflation. How will that affect strategic planning? If we view strategic planning to be long-term planning, it is not about moments or quick in-and-out of market plays but rather measured in years. It is interesting to see how the Fed’s manipulation of short-term rates has played out (remember that the past not necessarily a good indicator of the future) especially in the intermediate part of the curve where strategic planning often occurs.
Over the last twenty-five years, the Fed has had three periods of sustained rate hikes. Starting in 1994, the Fed raised Fed Funds 300bp from 3.00% to 6.00%. Over that same period, the 10-year Treasury only went up 157bp and within six months, the Fed was lowering their rate.
From June 1999 to May 2000, the Fed hiked rates 175bp. The 10-year Treasury rose 48bp over the same period. Within seven months, the Fed was lowering their rate.
From June 2004 to July 2006, the Fed raised short term rates 425bp. The 10-year Treasury went up a mere 60bp. 14 months later the Fed was lowering their rate.
Some consistencies surface. The Fed’s short-term hikes do not necessarily produce parallel shifts in the intermediate or long parts of the Treasury curve. Also, the Fed either gets ahead of inflation or they tend to “over shoot” their level as within very short periods of time, they have reversed their direction. In any case, it appears they have done a pretty good job of maintaining order where inflation is concerned. In addition and in hindsight, it has been beneficial to avoid knee-jerk investing and stick with long term planning where strategic asset allocation is concerned. Getting ahead of the game means something altogether different for strategic investing.
To learn more about the risks and rewards of investing in fixed income, please access the Securities Industry and Financial Markets Association’s “Learn More” section of investinginbonds.com, FINRA’s “Smart Bond Investing” section of finra.org, and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) “Education Center” section of emma.msrb.org.
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.