By now, most investors should be acutely aware that the rise in interest rates, as benchmarked by the 10 year Treasury bond, has been systematically re-pricing the global pool of risk assets. The process began with gold last fall and has worked its way through the fixed income complex, emerging market equities, and is now taking a toll on REITs.
What might come as a surprise to some is that the Federal Reserve's open ended Large Scale Asset Purchases (LSAP) program (referred to as QE3) has played a leading role. While there is much debate on the efficacy of these LSAPs, the timing of each LSAP has been associated with a rise in the 10 year bond yield - contrary to popular belief.
Considering a world where LSAPs are stimulative, we would then expect the opposite from the Federal Reserve via (actual) tapering of QE3. For interest rates and economic growth expectations to remain at current levels, one would expect a rebound in private sector credit growth, which unfortunately has been slowing since mid-2012.
We estimate a fair value for the 10 year bond yield at approximately 2.6% versus the recent yield of ~2.8%. The current business cycle by many accounts has been the "Great Normalization" of the economy from consumer sentiment to auto sales to a recovering housing market. If this normalization cycle is in the late innings and stimulation via QE3 is being reduced, we would expect our 2.6% estimate to be optimistic.
Fundamentally speaking, we would argue rates should fall and prices in fixed income to partially rebound. However the trend in the 10 year yield has been extremely strong since crossing its 200 day moving average back on May 7th. Until that trend stops, we continue to pare back exposure rather than add exposure. Lastly, domestic equities are a crowded trade at this point and are arguably fully valued based on recent earnings or on a normalized basis. Thus chasing returns might be less rewarding than holding onto some dry powder until rates settle down.
Re-pricing Risk Assets
Gold was arguably the first asset class to be impacted by rising rates. Gold in terms of a traditional safe asset can be thought of as the ultimate safe bond. It does not carry a sovereign or default premium. However, because it pays no interest and is a long-lived asset, it is sensitive to interest rate movements. As real interest rates rise, it becomes more costly to hold gold and vice versa.
Figure 1 represents a plot of the monthly price of the Gold Trust SPDR (NYSEARCA:GLD) versus the inverted yield of the 10 year U.S. Treasury bond. The bottoming process of yields (inverted in the figure) coincided with the topping process of the gold ETF as indicated by the 10-month moving average.
Figure 1: Gold Versus 10 Year Bond Yields
Long-dated Treasuries, as shown in Figure 2 using the iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT), shows a similar topping process, with the peak in the moving average coming slightly later in February '13 versus gold in October '12.
Figure 2: 20+ Year Treasury Bond ETF Monthly Adjusted Prices
The most recent asset class that has been impacted by the continued rise in rates is REITs. Figure 3 highlights the monthly adjusted prices of Vanguard's REIT ETF (NYSEARCA:VNQ). The darkened oval indicates where the monthly close "would" be if the current month (August) ended on yesterday's close. The decline below the 10-Month moving average represents a possible beginning of a near-term topping process within REITs.
Figure 3: Vanguard REIT ETF Monthly Adjusted Prices
Data Source: Yahoo!Finance
Wasn't the purpose of QE3 to drive interest rates lower? In theory - purchasing bonds should drive bond prices up which lowers the associated yield. As figure 5 shows, the impact of the 3 LSAPs (identified in the grey columns) is contrary to the typical explanation. Rather we believe that there is some influence between the LSAPs and economic growth via increases in bank reserves above current loan demand requirements. The pathway however is not clear cut and given the stagnation in traditional credit growth -- one explanation could be based on a rebound in the adjacent shadow banking system, which utilizes the repo market and securitization process to provide credit intermediation functions.
Figure 5: 10-Yr Rates, Fed Funds, and QE Periods
What is a Current Fair Value Yield Estimate?
We highlight two fundamental ways to measure a fair value for the 10 year bond. The first is based on the Expectations Hypothesis, which equates the yield on a long-term bond and the average short-term rate experienced over the maturity of the long bond.
We can model short-term rates based on the parameters set by the Federal Reserve and a regression model based on short-term Fed Funds rate as it is related to unemployment and inflation rates. Figure 6 details the model based on regression parameters provided by Paul Krugman and the underlying function from Greg Mankiw. Estimates are from the latest Federal Reserve forecasts. The current implied rate for 2013 and 2014 is 2.40% and 2.75%, respectively.
Figure 6: Expectations Hypothesis Fair Value Estimate
A second method is to use real-time economic data including the core-inflation rate, the ISM's Manufacturing New Order Index, and the short-term rate based on the 3-month T-bill. The regression outcome is shown in Figure 7.
Figure 7: 10-Yr Yield Regression Model Estimate
Using the latest ISM New Order index value of 58.3, core inflation of 1.7%, and the 3-month Treasury Rate of .05% gives an estimated 10 year yield of 2.96% versus 2.54% a month ago. Using the average 3-month ISM New Order Index of 53.0 lowers the rate to 2.61% and appears more reasonable.
While there are other ways to measure fair value, these two measures are reasonable proxies based on fundamentals and historical evidence. Both suggest that the current rate is now ahead of itself.
Forward Look at the Taper Impact
Back to a world where LSAPs are stimulative - the reduction in the LSAP program must be offset by loan growth in the private sector (commercial banks as well as credit unions and S&Ls). Currently the aggregate commercial bank loan and lease portfolio has been slowing since last summer. This will clearly have to change to reflect a more healthy and growing economy. The one caveat is the relative rebound in effective money created via the shadow banking system. Unfortunately at this time most data measuring the size of the shadow system is rather lagging in nature.
Figure 8: Year-over-Year Growth in Private Bank Credit
Fundamentally speaking, we would argue that rates have risen too far and to fast based on a modestly improving economy, which has been supported by four years of aggressive monetary policy. With that outlook, adding exposure to assets that have sold off recently might make sense tactically (short-term) including longer-dated fixed income investments.
However, the short-term trend in the 10 year yield has been extremely strong since crossing its 200 day moving average back on May 7th (see Figure 9). Regardless of the reason why - the trend continues to be up and we believe that alone should keep investors wary of being tactically long falling rates.
Until that trend stops, we would continue to pare back exposure where prudent rather than add exposure. Over the intermediate-term, with QE3 being wound down via tapering, we would look to changes in aggregate bank credit growth to signal future rate direction.
Lastly, while there is some relative strength in domestic equities, it has become a crowded trade and valuations as a whole are not attractive considering the business cycle. Having some dry powder in this environment might prove to be rewarding.
Figure 9: 10 Year Yields
Disclosure: I am long VNQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Clients of Smith Patrick Financial Advisors own VNQ at the time of this writing. This is article is written for informational purposes and we believe investors should perform their own due diligence before making investment decisions.