By Daniel Himelberger
The third quarter of 2016 kicked off with historic events in financial markets, fueled by post-Brexit volatility. On July 8th, we saw record-highs for the S&P 500 at 2129.90 and record-lows in the 10- and 30-year treasuries at 1.359% and 2.099% respectively. Since that day, we have seen new records in equity markets while longer Treasury yields have approached pre-Brexit levels. This includes a 20+ basis-point increase in yields from the 3-year out to the 30-year Treasury. The graph below shows US Treasury curve movements across all tenors from the record lows on 7/8/16 (yellow) to 9/22/16 (green).
At its September meeting, the Federal Open Market Committee (FOMC) once again elected to hold interest rates steady. This marks the sixth consecutive meeting with no interest rate increase. The Committee's statement following the meeting was much more hawkish than after previous meetings, pointing out "solid" job growth and increased consumption. The FOMC is pleased with recent economic numbers and stressed that the case for an interest rate increase has strengthened. The post-meeting statement said that "Near-term risks to the economic outlook appear roughly balanced" and hinted that we will see tightening later this year. Our view is that there will be at least one interest rate hike later this year, with December being the most likely month.
At the beginning of the third quarter, Cumberland Advisors' view was that the lows in interest rates were set by the post-Brexit Treasuries rally. We took advantage of this rally by selling longer-maturity assets to shorten durations and harvest profits. The goal for Cumberland Advisors' taxable total-return portfolios throughout the third quarter was to begin focusing more on preservation of capital as we witnessed record lows in the 10- and 30-year US Treasury bond yields. Faced with these record-lows, it was our decision to increase the weighting on the short-end of the barbell while waiting for more attractive opportunities.
As proceeds from selling longer-duration assets were made available, our focus shifted to structuring portfolios defensively, given the expectation of higher rates in the future. We increased our weighting in two-year Treasury floaters and agency multi-step securities. The two-year Treasury floater protects against rising interest rates by adjusting the coupon weekly based on the 13-week T-bill auctions. The floaters are being positioned as a cash alternative that protects the principal investment while the coupon moves in lockstep with interest rates. The agency multi-step coupons also protect against rising interest rates by featuring multiple coupon increases (step-ups) over the life of the security. If rates go lower or remain the same, the security is generally called and replaced to maintain the defensive structure of our portfolios.
Moving into the fourth quarter, we will look to continue shortening durations, as we expect to see an ongoing rise in interest rates. Some of the shortening will continue to come from bonds rolling down the curve while the rest will come from selling longer-duration assets with embedded profits. Our focus will remain on preservation of capital while we wait for higher rates. Our goal with total-return management is to manage portfolios through a full interest rate cycle by finding value along the yield curve. Our barbell strategy helps us do this by not constricting our management to certain maturities and by giving us the ability to over- and underweight certain parts of the curve where we identify value. For now, our view is that there is more value on the short-end of the curve, and the rewards and incremental income for being long do not outweigh the risks at this time.
