Last week, the Fed came out and announced a new round of quantitative easing. In the news conference, Chairman Bernanke stated that interest rates will likely be held low until mid-2015 or until unemployment decreases to below 6.5%. Unemployment is currently at 7.9%.
As a result of Fed policy and because of the recession, interest rates have been historically low. There may be an investing opportunity here for the longer term investor because interest rates are at a lower bound and are only likely to be higher in a few years. The only question is: when?
An efficient way to take advantage of interest rate movements is through ETFs that replicate the movements in interest rates. In this case, I discuss ticker TMV, which is the Direxion Fund's 20+ Year Treasuries Bear 3X shares. This fund increases in value when the value of long-term (20+ year) U.S. Treasury Securities declines, by a factor of 3 times. It essentially allows you to short bonds with 3X leverage. Long term bonds will be the most sensitive to any changes in interest rates.
Before discussing the bond market, consider how the price of this ETF should behave based on interest rates. The duration of a 30-year bond is 17.5. Duration is the weighted average number of years it will take to receive the cash flows of the security, both coupon payments and principal. A 30-year, zero-coupon bond will have a duration of 30 because all of the cash flows will occur in year 30. Duration, as the math works out, also measures the percentage change in the value of the security for every percentage point change in the underlying interest rate of the bond. When interest rates go up by 100 basis points, a regular 30-year bond will lose about 17.5% of its value. Because TMV is a bear fund, it increases in value; in this case, it will increase by 3x the percentage decrease in the value of the underlying bond. In the case of a 100 basis point increase in the interest rate, this ETF should increase in value by 3x17.5%=52.5%.
This chart is TMV's performance over recent years as interest rates have compressed and increased in value.
The real question related to this security and rising interest rates is "When?". Interest rates, as economic activity improves and quantitative easing ends, are very likely to increase. It is just a matter of timing that will determine your return. The longer it takes for rates to rise, the lesser your annual return. Let's use a 100 basis point change as an example. Per above we calculated that a 100 basis point increase will provide a 52% return. That 52% translates into an annual compounded return depending on the when question, how long you need to hold the security to realize those rate increases. Below is the annual compounded return based on the length of the holding period needed to realize a 100 basis point increase.
So let's say that rates start rising in mid-2015, consistent with Chairman Bernanke's statement about the Fed funds rate. You wait another year to mid-2016 for rates to rise by 100 basis points; this will yield a compounded annual return in 3.5 years, if you purchased the security today, of 12.8%. This is a solid return. If rates rose sooner, you will enjoy an even better return per the schedule above.
30-Year U.S. Treasury Rate
So the section above analyzes how the price of TMV will be affected by rate increases. This section will discuss how the interest rate itself is determined and the forces in play that are determining it. In the case of a 30-year U.S. Treasury Security, the interest rate is determined as the sum of the real interest rate, a premium for inflation, and a premium for the long term of the bond. There is no premium at this point in time for credit risk for U.S. government securities as they are considered risk-free.
30-Year U.S. Treasury % rate = Real Interest % + Inflation % + Term Spread %
Currently, the 30-year Treasury rate is 2.87%.
That is very close to the 2.0% long-term inflation rate expected over the term of the security. The reason that this rate is so low is that the real interest rate is low; in fact, it is negative, driving down the overall rate. Additionally, the Fed has been active in the long end of the Treasury market during its Operation Twist portion of its quantitative easing program, causing the term spread to decline and the yield curve to flatten. The result is a 30-year rate that is near historic lows.
-Real Interest Rate %-
The real interest rate is currently negative. The real interest rate is driven by the level of savings and investment in the economy. Economic theory says that Savings equals Investment in the economy. Savings, as intermediated through banks, should equal the level of investment in an economy; the interest rate will lead the market to equilibrium. Between the housing market and businesses' reluctance to invest because of uncertainty in the economy, investment has been down. This has driven down rates because there is excess savings relative to the amounts required for investment. Below is a graph of my calculation of the real interest rate.
Since 2007, annual investment levels have declined but recently have been on the rebound. See below for a breakdown in investments by category. Savings, during the crisis, increased. Savings is currently decreasing.
There are a couple forces in play that will determine changes in the real interest rate going forward, starting with the investment side:
-Europe. Europe is not in as dire shape as it was 6 months ago or within the last 3 years. There is less risk of a severe downturn or catastrophe there for 2013. The euro has strengthened relative to the dollar in the past 6 months and will likely improve into 2013 as the economy recovers there.
-China. China is coming out of its slump and is expected to rebound. Both Europe and China point to a world economy that will likely not contribute to a drag in U.S. investment confidence unlike in previous years. Further, both economies will be relatively more appealing and competitive with the U.S. for investment dollars in the next few years relative to the last few years.
-U.S. Fiscal Cliff. This is the big domestic question contributing to uncertainty; the election created uncertainty a few months ago but that is resolved now. It appears that there will be a deal struck and the uncertainty around U.S. fiscal issues will not provide another reason for people and companies to not want to invest.
-Banks. See my article here about the state of banking. Bank margins are healthy now and loss rates are under control as compared to crisis levels. Banks are in a better position now than in any preceding year since the start of the recession to lend and absorb more risk. This facilitates the investment process and is the reason banks have seen solid rates of return in 2012. In previous years, only the best of the best credit risks were considered; now, the ability to take risk may lead to consideration of a wider spectrum of investment projects, thus expanding the demand schedule for investment funds.
-Housing. Housing has bottomed out and is on the rise. This will also increase the demand for investment funds going forward. Levels are improving although not even close to being near previous levels. Either way, it should be a growing and not declining use for investment funds.
-Expectations of rate increases. Many people argue that the very idea of a rise in interest rates will spur people to try to lock in low interest rates while they can get it. This will be an added use of funds as these types of timing decision makers enter capital markets.
Funds that investment projects need are supplied by savers in the economy, both domestically and from around the world. On the savings side, just like the investment side above, there are also forces in play that will affect the rate of interest:
-President Obama is insistent on taxing the highest earners for a deal. These high earners add a significant amount of savings to markets. Per the Consumer Expenditure Survey from 2011, people earning $150k+ saved up to 46% of their after-tax income which represented about 61% of total savings added to capital markets.
Generally, I agree with the supply-side crowd which believes that more money saved by high earners trickles down to other people through saving this money and then investing it into businesses that provide jobs and grow the economy. However, in today's environment, there is an excess of the supply of money relative to the amount of investment projects that are being funded; that is why the real interest rate is negative. If real rates were higher, I would generally agree that getting more money to fund investment projects would be a good thing for economic growth. In this environment, however, I believe that this argument does not hold because interest rates are so low and indeed negative. Adding more savings into the market, via supply-side-style tax policy, would only add more excess savings into to the market.
The graph below is a summary of the sources of Savings and Investment in the economy:
-Inflation Rate %-
Over the life of a 30-year bond, I expect 2% inflation. The current Fed has indicated a target of 2% as policy and, as of last week, has even indicated that it may tolerate levels slightly above the 2% target in the near future.
-Term Spread %-
I calculate the term spread by subtracting the expected inflation rate over thirty years (i.e. 2%) and the 1 Yr. LIBOR rate from the 30 Yr. bond. The historical graph is below. Notice that the spread is less likely to decline to very low levels as rates get closer to the lower bound; accepting a lower rate on long-term debt is just not worth it at lower bound levels. See Paul Krugman's note about the term spread here.
Typically I would not recommend going against the Fed; that is about investment rule #1 for me. The Fed is focused on the long end of the curve currently and also MBS. In fact, the announcement last week calls for it to buy about $85 billion worth of MBS and long-term securities per month. Currently, there is about $1.2 trillion of long-term securities outstanding per Treasury data and the Fed holds about $205 billion of that amount per the NY Fed's data; that works out to about 17% of the entire market. The Fed will continue to buy long-term securities and the Treasury will likely continue to issue them.
The extent that the Fed can affect this market's current price depends on the extent of its purchases, the extent of the Treasury issuing new long-term bonds, and the extent to which non-monetary authority market participants leave the long-term market as rates decline. 30 years is a long time to hold your money at 2.87%.
The Treasury has issued about $176 billion of long-term bonds in the last year which equals about $14.7 billion per month. If the Treasury continues that level of issuing next year, that $14.7 billion will be about 32% of the Fed's expected $45 billion QE purchases per month. Per the Desk's website at the NY Fed, the Desk will use about 29% of its total open market purchases on 10+ year securities. So, it appears that open market purchases over the course of the next year will be about enough to soak up new issues and not much more.
What this says, in my opinion, is that the term spread will remain intact and not compress because of Fed easing. Fed purchases will not exceed the pace of new issues created.
As Jamie Dimon said last week, "The table is set for 4% economic growth." The consumer is getting better, housing turned the corner, China has rebounded, Europe looks to be relatively stable, and uncertainty around the US's fiscal situation will soon be resolved.
Per the original equation above, the 30-year rate of 2.87% = 2% inflation - 0.90% real rate + 1.77% term spread.
There appears to be a situation where market forces, in contrast to previous years, will push real interest rates higher. Growth would mean a wider schedule of investment opportunities in the economy that would need to be funded by less savings due to the policy of taxing the high earners that contribute much of the savings already in the economy. Tax policy will lead to less savings brought to the market and, on the investment side, there is an increasingly wider investment demand schedule because of all the factors cited above. Both economic forces seem to point to upward pressure on real interest rates. It will get harder and harder for the Fed to keep rates at their present levels as the real interest rate rises and their tolerance for inflation rises to 2.5%. As a result, I expect longer term rates to rise from current levels, if not next year, then in the next few years.
The widest changes in bond values that will be caused by movements in interest rates will be realized on the long end of the curve where there is the most sensitivity. A great way to take advantage of this decline in bond values is to buy an ETF that replicates the inverse effect of declines in those bond values. TMV replicates this effect by 3X.
The Fed has indicated that it will keep the fed funds rate at the lower bound for until at least mid-2015. If real rates moved up, the Fed would need increasingly higher levels of easing to keep rates where they are presently. TMV offers 3X inverse leverage on movements in long-term bonds. You know the move is coming; the extent of the move in unison with the leverage will provide a good return even if you need to hold the security for a few years.