Waiting on Rates to Rise is a Bad Bet for Retirement Income: Stephen J. Huxley, chief investment strategist, Asset Dedication LLC, and professor of business analytics, University of San Francisco
Rates have been hovering at the lower end of the scale since 2001. Though the media likes to focus on the near zero rate for federal funds, the fact of the matter is that yields on 1 to 3 year maturities in previous periods have actually been lower than they are today for a surprising amount of the time.
For instance, the 1-year Treasury yield on 10/14/10 was a stingy .22%. Although this is indeed low, it has been even lower 20% of the time since 1927. The same holds true for 2- and 3-year Treasuries. At .38% and .60%, they are low, but have been lower 14% and 11% of the time, respectively. Thus, it would not be unprecedented for low rates to hang around for awhile.
What this means is that anyone waiting for rates to rise may be waiting for longer than they realize. That brings up the question: Is waiting a good idea for someone wanting to buy bonds? The argument in favor of waiting is that bonds will be cheaper if and when rates rise. The argument against waiting is that short-term rates are so low that the portfolio may never catch up even if rates to begin to rise. The solution to this dilemma will depend on how much and how fast rates rise.
We recently did some research on that issue and concluded that waiting is not a good bet. The case analyzed was an investor who planned to retire in two years and wanted to cover the first eight years of retirement income using individual bonds with staggered maturities whose redemptions and coupon payments would precisely match the income needed over those years. To ensure safety and predictability, the securities would consist of CDs, agencies, and/or Treasuries (whichever had the highest yield for each year) held to maturity. The first year would be covered with cash.
In this case, should the advisor: a) buy a ladder of bonds now, maturing in 3 through 10 years or b) wait two years in cash, then buy bonds maturing in 1 through 8 years? The trade-off is that the 3- to 10-year bonds are further out on the yield curve and thus pay higher rates than 1- to 8 year bonds. The higher rates mean the cost of covering the first 8 years of retirement income will be lower than the cost of 1- to 8-year bonds to match the same income stream, unless rates rise fast enough and far enough to offset the advantage of buying the 3- to 10-year bonds now.
Our “deferment analysis” shows that rates had risen fast enough and far enough to offset that advantage less than 10 percent of the time since 1927. Even when rates were rising to their highest peak in history, from 1947 to 1981, they rose fast enough only 14% of the time. Since 1990, they have never risen fast enough to make waiting pay off.
The conclusion to be drawn from this analysis is that waiting to buy bonds to supply income is not a good idea. This conclusion is reminiscent of the old saying: “A bird in the hand is worth two in the bush.”
Summary of TrimTabs Weekly Liquidity Review, October 18, 2010
• We Turn Cautiously Bullish (50% Long) from Neutral (0% Long) on U.S. Equities
• U.S. Economy Improves in Early October: Wages and Salaries Rising Sequentially, and Labor Market Demand Picking Up.
• Demand Indicators Also Generally Favorable. We Are Not More Bullish Because Companies and Insiders Not Buying Much.
We are turning cautiously bullish (50% long) from neutral (0% long) on U.S. equities. The main reason we are changing our stance is that key macroeconomic indicators have improved:
• Real-time tax data indicates that wages and salaries started to rise sequentially in early October. We estimate that wages and salaries rose 3.8% y-o-y in the two weeks and three days ended Wednesday, October 13 (we end our period on Wednesday, October 13 rather than Thursday, October 14 to work around a calendar quirk). We are surprised at this improvement, but we are not aware of a calendar quirk or other factor that explains it other than stronger wage and salary growth.
• Labor market demand seems to be picking up a bit. The TrimTabs Online Job Postings Index rose 39.4% y-o-y in the latest week, exceeding the average weekly growth rate of 36.8% y-o-y in the past three months. Also, the ISM Non-Manufacturing Employment Index edged into expansion territory at 50.2 in September from 48.2 in August. On the negative side, the four-week average of initial unemployment claims bounced off a ten-week low, rising 2,250 to 459,000 in the latest week.
Another reason we are somewhat bullish is because our demand indicators are generally favorable.
• The TrimTabs Demand Index, which uses regression analysis of 21 flow and sentiment indicators for market timing, was extremely bullish at 83.5 on Thursday, October 14 (readings above 50 are bullish).
• Short interest was almost unchanged in September even though the S&P 500 shot up 8.8%. The stubbornness of the shorts is bullish from a contrarian perspective.
• One reason for caution is that the flows of leveraged U.S. equity ETFs are not as auspicious for stocks as they were a week ago. In the past week, leveraged long U.S. equity ETFs redeemed 0.5% of assets, while leveraged short U.S. equity ETFs redeemed 1.4% of assets. These flows are an excellent contrary indicator, so it not bullish that outflows from leveraged long funds and inflows into leveraged short funds have diminished.
We are not turning more bullish because companies and corporate insiders are not signaling much optimism about the future based on their actions in the stock market.
• New stock buybacks got off to a slow start to earnings season, totaling just $3.1 billion in the past week. More broadly, companies are no longer shrinking the float. Corporate selling (new offerings + net insider selling) exceeded announced corporate buying (new cash takeovers + new stock buybacks) by about $6 billion in September, and corporate selling is running pretty even with corporate buying in October.
• Corporate insiders sold $5.8 billion in the past month, a whopping 18.1 times more than the $320 million they bought. We expect insider selling to explode in the next few weeks as earnings season blackouts lift, assuming the stock market does not sell off.
In our model portfolio, we are 50% short XLE (SPDR Energy) and 100% long XLK (SPDR Information Technology).
Reid Thunberg ICAP, Oct. 18, 2010
As long-term subscribers of the RT-ICAP service know, we have never been in favor of complete transparency on the part of the Federal Reserve. Admittedly, some of our resistance is self-serving for it diminishes the value of our expertise as "Fed Watchers." But more importantly, it risks exposing the Federal Reserve as being like the all-knowing, all-powerful Wizard of Oz—neither omniscient nor omnipotent. The Fed needs to retain some mystique.
The Fed has maneuvered itself into a situation which we do not believe it can extricate itself without losing credibility, which ironically Chairman Bernanke in his speech at the Boston FRB on Friday said was of "utmost importance." The minutes of the September 21 FOMC meeting stated that "several" members believe that if the pace of economic recovery does not strengthen or underlying inflation move back toward a level consistent with the Committee's mandate, appropriate action should be taken "soon." In the four weeks since the meeting, real sector economic data on the whole have continued to indicate activity remains below potential and inflation below what is desired, not to mention on-going abysmal labor markets. In his speech Friday Bernanke said, "The recovery has slowed in recent months and is likely to continue to be fairly modest in the near term." The only economic sector he described as doing well is business spending on equipment and software but even activity in that sector "has slowed." And while he said the "preconditions for a pickup in growth next year are in place...growth next year is unlikely to be much above its longer-term trend." As for inflation, he noted that "measures of underlying inflation have been trending downward..(and) will remain subdued for some time."
Bernanke said nothing to disabuse investors that more quantitative easing is coming. Indeed, he concluded by saying "the FOMC is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation over time to levels consistent with our mandate." Such after arguing that the Fed was falling short of achieving either mandate. To be sure he did hedge himself a bit by saying "the FOMC will have to take account of the potential costs and risks of nonconventional policies, and, as always, the Committee's actions are contingent on incoming information about the economic outlook and financial conditions." But repeatedly in the speech he noted the economic "uncertainties" which in our opinion are all to the downside. Hence, additional quantitative easing as soon as the November 2-3 FOMC in a fait accompli.
Finally, what bothers us is that Fed is now spoon-feeding traders. These guys are big boys getting paid big bucks. They should not be spoon-fed. Let them figure some things out for themselves. That is why they are paid the big bucks.
The Treasury sentiment indices bounced back slightly in the RT-ICAP Money Manager Sentiment for the week ending October 15. The end-of-December index was 47 versus 45 last week. The end-of-June '11 index managed to eke out a 1-point gain to 42, after flirting with the year-to-date low last week. 25 money managers controlling $1,401 billion in assets participated in the survey.
Economic data during the holiday-shortened week were mixed in both the real sector and the price indexes. Overall producer prices rose more than expected due to a jump in the food component, but that did not carry through to the CPI, where the overall index was up just 0.1% and core prices were flat for a second straight month. The YOY and 3-month annualized changes in the core CPI slipped further below the Fed's comfort zone. Retail sales were surprisingly upbeat, and suggested that real consumption spending rose a little more in Q3 than in the first half. However, a rebound in initial claims disappointed. The FOMC minutes contained nothing to suggest that the widely expected QE2 is in any danger of derailment.
Money Manager Responses—General Market Sentiment
* The majority (64%) of respondents did not expect multiple dissents on the QE vote at the next FOMC meeting to result in a negative market reaction. A significant minority (36%) felt the market would react adversely if any voters joined KC President Hoenig in voicing opposition to QE2.
* Opinions on the outlook for GDP appear to be all over the board. 36% of respondents felt that the U.S. would experience just 1 year of GDP growth of 2.5% or less. 32% felt that the losing streak would extend to 2 years. 24% thought that the economy would under-perform for more than 3 years. 8% looked for 3 years of sub-par GDP growth.
Money Manager Responses—FOMC Policy
* 100% expect the Fed to hold rates steady at the November 2-3 FOMC meeting, unchanged from last week. 0% vs 0% expect an ease. 0% versus 0% expect a hike.
* 100% expect the Fed to hold rates steady at the Dec 14 FOMC meeting, unchanged from last week. 0% vs 0% expect an ease. 0% versus 0% expect a hike.
* 95% versus 100% last week expect the Fed to hold rates steady at the Jan 25-26 '11 FOMC meeting. 0% versus 0% expect the Fed to ease. 4% vs 5% expect a hike.
Barclays Capital Global Economics Weekly (excerpts)
QE II hasn’t started, but it’s already working
• Expectations of QEII are already moving markets, contributing to higher stock prices and a weaker dollar.
• These market moves and better-than-expected economic data have reduced the likelihood of continued below-trend US growth.
• Investors should be cautious, as the effects of QE are temporary.
• Tensions stemming from China’s currency policy persist, and continued dollar depreciation only adds to that pressure.
QE II hasn’t started, but it’s already working
Market rallies in fixed income and equities, as well as better-than-expected economic data, should reduce fears that the US economy is mired in an extended period of below-trend growth that will push the unemployment rate back up above 10%.
The only action the Fed has taken since US economic growth slowed in the spring is to begin re-investing maturing and pre-paying MBS into US Treasuries to prevent its balance sheet from otherwise shrinking. The central bank, however, is having a much bigger impact on markets and growth prospects than such a minor action would suggest. Fed communications suggesting a near-term resumption of outright asset purchases has contributed to a significant move in market prices that should have a positive effect on the US economy in coming quarters. Since the US economy has been one of the laggards in the global recovery and remains the world’s largest, improved prospects for US growth have positive implications for global markets more generally.
Risks declining for continued below-trend US growth Most economists (including ourselves) lowered their forecasts for US H2 GDP growth following disappointing employment reports (beginning in May) and a much lower-than-expected Q2 GDP report released in July, which included significant downward revisions to consumer spending in previous quarters. Indeed, many (but not including ourselves) projected that the below-trend growth recorded in Q2 would continue into next year, implying that the unemployment rate would reverse its recent decline and move back up over 10%.
Recent market moves and economic data, however, have reduced the likelihood of an extended period of below-trend growth. The report on September retail sales—which was better than expected and included upward revisions to previous months—suggests that consumption is accelerating, currently tracking around 2.9% in Q3 after growing around 2% in the first half of the year. Trade data through August imply that while net exports are likely to continue to subtract from growth, the size of the drag will be nowhere near that of Q2—which amounted to a staggering 3.5 percentage points. And while employment data have continued to disappoint, higher frequency data on jobless claims have shown no tendency to deteriorate, casting doubt on forecasts for a resumption of a rising unemployment rate. Overall, Q3 GDP growth is tracking slightly stronger than our forecast of 2.5%, confounding expectations of another quarter of sub-2% growth.
Market rally and dollar decline boost US growth prospects
Meanwhile, markets have rallied strongly and the dollar has fallen since the Fed began to open the door for further QE with the FOMC statement following the August 10 meeting. Bond yields are now a full percentage point below first-half averages, contributing to sharp increases in mortgage refinancings and corporate bond issuance. Stock prices have risen some 10%, which boosts household wealth and should provide some support to spending and confidence. Finally, the trade-weighted dollar has fallen by roughly 5% since August (and close to 10% since its peak in early June), which will provide a boost to trade (and inflation) over time.
QEII jolt to markets is temporary
A healthy dose of caution is in order, however. To the extent that market moves are being driven by expectations of significantly more QE, those expectations can be disappointed, and any QE that does occur provides only a temporary boost. Markets will eventually anticipate a withdrawal of the extraordinary liquidity that the Fed has been and is likely to continue to provide. It is also worth noting that mid-term elections and outcomes on tax policy present risks in both directions.
This week’s data releases from other countries were largely unremarkable and did not do much to change perceptions. The most notable news came out of China. Reserve requirements were hiked at the beginning of the week for the fourth time this year, but this action is unlikely to restrict credit growth significantly. Indeed, reports for September indicated that new lending moved up further and confirmed that FX reserves rose sharply in Q3, reflecting a surge in capital inflows. Trade data for September showed a modest decline in the surplus, reflecting a slowing in export growth. The RMB continued to appreciate against the dollar at a more rapid pace than had been observed in the latter part of September, but overall it has appreciated less than other currencies have (ie, the RMB has depreciated on a trade-weighted basis). Notably, European policymakers and politicians ramped up their criticism of China’s currency policy in recent days, reflecting the marked depreciation of the RMB against the EUR. Bottom line: tensions around China’s currency policy persist, and continued dollar depreciation only adds to that pressure, as other policymakers do not welcome appreciation in their own currencies.
Calendar:
Tuesday, Oct. 19:
ICSC-Goldman Store Sales, from the International council of Shopping Centers and Goldman Sachs;
Housing Starts for September, from the U.S. Department of Commerce and U.S.
Department of Housing & Urban Development.
Wednesday, Oct. 20:
Beige Book, anecdotal information on the economy from the Federal Reserve Board of Governors
Thursday, Oct. 21:
Jobless claims for the week of Oct. 9., from the U.S. Dept. of Labor.
