In uncertain times, many investors understandably want to minimize volatility and reduce exposure to duration-sensitive assets by passively allocating to front-end strategies.
However, simply shortening duration isn’t enough of a defense in most hiking cycles: The purchasing power of passive Treasury investments – not just in money market space, but also in 1- to 3-year Treasuries – simply erodes too much.
By actively managing interest rate exposure while diversifying portfolios across a range of asset classes, PIMCO seeks to help mitigate the erosion of real capital in short-term and low-duration strategies while aiming to offer more attractive relative returns than traditional cash investments.
Here on the West Coast, enjoying the ocean surf is a fun way to relax, especially when the waves are moderate and the tides are gentle. But every so often, water from the breaking waves pools up on the shore, creating swift backchannels flowing out to sea. These rip currents are tough to spot and often drag unsuspecting swimmers far away from shore. As frequent beachgoers will tell you, getting out of a riptide requires a plan for survival and exit; namely, swim perpendicular to the current and above all else, remain calm.
Investors are sometimes caught unawares by market “riptides.” For example, in the coming quarters as the Fed continues its normalization of rates and balance sheet, the key for investors is to have a plan to exit successfully and emerge unscathed. When yields are rising, many financial advisors suggest reducing exposure to interest rates (aka duration). In general, we agree. But much depends on how investors reduce that exposure. Simply focusing on passive strategies at the front end of the yield curve during tightening cycles may be less ideal than one thinks, as the path of least resistance can often leave you caught in a rate hike riptide.
According to our research, during past tightening cycles since 1994, investors who sought refuge via strategies linked to passive 1- to 3-year U.S. Treasury indexes have tended to underperform cash. While some marketers may tout these indexes as a way to generate potential positive absolute return (generated from the higher income) in owning 2-year Treasuries during periods of rate hikes, what this statistic doesn’t tell you is how well your relative return might be versus investing in a perceived “risk-free” liquid asset, such as cash or cash equivalents proxied by the fed funds rate.
Once you subtract out that risk-free return, it becomes clear that many front-end investors have not been adequately compensated for interest rate risk during past hiking cycles. See Figure 1, which details the rolling 6-month excess return for the Bloomberg Barclays U.S. Treasury 1-3 Year Index relative to the same-period return on cash (using the fed funds rate as a proxy). The takeaway is that simply shortening duration isn’t enough of a defense in most hiking cycles: The purchasing power of passive Treasury investments – not just in money market space, but also in 1- to 3-year Treasuries – simply erodes too much. In other words, hiding out in passive front-end strategies may appear to offer prudent protection versus longer-duration benchmarks, but it is a suboptimal way to decrease duration.
Moreover, allocations to these shorter- but still fixed-duration static strategies could actually be punitive to capital preservation due to the historical volatility at the front end of the yield curve during tightening cycles as market rates recalibrate to the Fed’s expected terminal rate. A large reason for this underperformance is market participants themselves underestimating the number of Fed hikes during a cycle, a tendency we’ve observed in the past three tightening cycles (1994–1995, 1999–2000 and 2004–2006). During the last hiking cycle in 2004–2006, market participants underestimated Fed policymakers’ reaction to a growing economy by more than 400 basis points over a two-year period (see Figure 2).
In other words, betting against the Fed during previous tightening cycles has been a dangerous game for many investors who have gone with the conventional flow by moving into passive front-end Treasury strategies.
However, many investors are making similar decisions today. Even as the Fed forecasts another three hikes in 2018 and two in 2019 (according to the most recent Summary of Economic Projections (SEP) and “dot plot”), the markets, once again, are echoing the old “show me” refrain, forcing the Fed to talk up low market-implied hike probabilities leading up to each rate hike so far this year. And the market’s odds of a hike in December 2017 are proving to follow a similar pattern of underappreciation of the Fed’s potential reaction starting several months before the prospective policy action (see Figure 3).
This behavior occurring this time around can be explained partially by recent research from the Federal Reserve Bank of New York staff, which shows markets may be incorporating a negative term premium of up to −0.50% into front-end rates. 1In other words, holders of front-end Treasuries are paying this premium to hedge the risk of a large deflationary shock to the economy. This is different than in past cycles when the term premium remained positive, meaning the underperformance of passive Treasury strategies could be under even more pressure should the Fed dots come to fruition.
Even with the Fed’s increased transparency this time around (thanks to those SEP forecasts and dots), markets continue to peg the terminal fed funds rate a full 0.50% lower than the Fed estimates and, as recently as last month, near the low end of PIMCO’s New Neutral range of 2%–3%. Yet past cycles have shown that the terminal fed funds rate usually ended up being higher than the neutral rate. This meant that once the Fed started tightening, paying up for portfolio protection in the front end – as is occurring now – was a fruitless endeavor until it became clear that the terminal fed funds rate had been reached for the cycle. As such, investors should expect and consider preparing for front-end Treasury rates to adjust higher beyond current expectations of future rates.
This combination of market mispricing combined with negative term premiums leaves little justification to just go with the flow in passive front-end vehicles. Instead, it may be time to consider actively repositioning portfolios for a cyclical period of rate hikes.
An active approach to managing portfolios mindful of rate hikes
Active short-duration investment strategies, combined with thoughtful portfolio construction, may offer attractive risk-adjusted returns and may seek to preserve purchasing power in a rising rate environment. By actively managing our interest rate exposure while diversifying portfolios across a range of asset classes, PIMCO seeks to help mitigate the erosion of real capital in short-term and low-duration strategies while aiming to offer more attractive relative returns than traditional cash investments. We employ several tactics:
Accentuate those risk factor exposures that tend to mitigate interest rate risk, highlight dynamic liquidity management and diversify the portfolio’s sources of income
Maintain positive carry versus U.S. Treasuries via short-dated investment grade fixed income securities
Employ rigorous bottom-up security selection, using our ability to discern credit and structural weaknesses as well as overlooked opportunities
Favor structurally senior cash flows within mortgages
Seek to capitalize on relative value between global yield curves and funding costs
Utilize hedges, including currency hedges, to reduce exposure to left tail risks (that is, to low-probability but potentially very damaging market events)
In uncertain times, many investors understandably want to minimize volatility and reduce exposure to duration-sensitive assets by passively allocating to front-end strategies. However, given the current trajectory of the Fed’s rhetoric and the poor historical track record for market-implied pricing, we are convinced that investors who simply buy and hold front-end Treasury indexes will probably end up where the flow goes, usually out to sea, leaving performance on the table. In contrast, investors who adopt actively managed front-end strategies at this point in the cycle may be able to mitigate the erosion of real capital experienced in passive benchmarks. It’s time to get out of the riptide.
In other words, betting against the Fed during previous tightening cycles has been a dangerous game for many investors who have gone with the conventional flow by moving into passive front-end Treasury strategies.
