FMD Capital Management

Volatile Interest Rate Moves Underscore the Inflation vs. Deflation Debate

Written by David Fabian, March 10th, 2014

It’s been a while since I addressed the topics of interest rates, tapering, and the impact of these concepts on our investment portfolios.  Last week’s better than expected jobs report significantly lifted both intermediate and long-term interest rates which gave us a flash back to 2013 as the markets digested the news.  Ultimately the increase in jobs is seen as a positive sign the economy is on track and underscores the Fed’s intent to taper their monthly asset purchase programs by $10 billion per month until the stimulus is completely removed.   

Last year the combination of surging stock prices and better than expected economic data led to a sharply rising interest rate environment.  Investors rotated away from bonds and into equities at a rapid clip to adjust to an environment that favored higher risk assets.  This pushed the 10-Year Treasury Note Yield to a high of 3.00% and catapulted stocks to new all-time levels.

However, that story has reversed in 2014.  The bond market this year has been fortified in part due to the combination of equity volatility and an over extension of yields.  Inflationary statistics have not matched the rising rates story and many portfolios that were underweight bonds are now adding them back to the mix as a hedge against slowing equity momentum.  Stocks have continued their upward march; however successive highs appear to be perceptibly slowing.

The iShares 20+ Year Treasury Bond ETF (TLT) is at an important technical cross road that will be a big tell on the future direction of both fixed-income and equities.  This measure of long-term treasury bonds has strengthened significantly since the beginning of the year and is now at a critical juncture of price support.

An extension above the previous high in TLT will likely be fueled by deflationary pressures if we start to see a pullback in stocks, slowing economic data, or perhaps an escalation of geopolitical conflict.  Conversely, we could see a break back below the 200-day moving average if inflationary pressures heat up, economic data blows past expectations, or Fed tapering significantly reduces the underlying bid for treasuries.

I expect that we are going to see some additional volatility in equities this year as a reasonable outcome from the natural ebb and flow of the markets.  That would also put pressure on junk bonds such as the iShares High Yield Corporate Bond ETF (HYG), which has been stretched to accommodate investors’ willingness to trade interest rate risk for credit risk.

The yield on HYG is now below 5% as a function of capital appreciation and a wave of deflationary selling would likely send assets fleeing from this sector.  I think that new money in high yield, senior floating rate notes, and convertible bonds is late to the party and may have trouble capturing the type of performance we saw last year.  Picking your entry points carefully will be critical to success in navigating these overbought themes.

Beneficiaries of a flight to quality from these areas will most likely include investment grade corporate bonds, mortgages, and treasuries.  The iShares Investment Grade Corporate Bond ETF (LQD) and iShares MBS ETF (MBB) are two areas to that will likely surge if we get a selloff in stocks or credit-sensitive securities.  Both of these ETFs can act as a safety net, similar to TLT, when investors switch to a risk off mindset.   However, it is important to keep in mind that higher credit quality and longer duration holdings are also more sensitive to swings in interest rates.

The bottom line is that you will have to tread a delicate balance in the fixed-income sleeve of your portfolio this year and be vigilant for numerous risks.  The right mix of credit quality, duration, and sector exposure will be extremely important to avoid any potential pitfalls.  In addition, the flexibility to shift in response to changing interest rate dynamics will play a big role in achieving a successful outcome no matter what is thrown your way.

If you are interested in learning more about our four-sleeve approach to income investing, I encourage you to download our special report on The Strategic Approach To Income Investing.