In a persistently below-market rate environment, financial innovation is likely to be aimed at intermediating risks, which may not be fully understood nor correctly valued - junk bond ETFs, emerging market debt funds, and the relentless hunt for dividend flows to replace the income that bonds used to provide, to name a few. Innovation is usually considered good, but in the current climate, the financial innovation is more aptly described as destructive because end-investors will most likely lose amounts exceeding their prospective returns and risk tolerances. Why? Because today's yield-enhancement products are rooted in assumptions about risk and reward, which have been behaviorally skewed, and now those rate expectations are shifting.
The Rationality Threshold
Let's assume that there are two different mindsets associated with interest rates. There's the mindset when rates are suppressed below their natural rate, which I will call the "rationality threshold," and a corresponding mindset where rates are at or above the threshold.
- With rates below the rationality threshold, further reductions serve no purpose for behavior modification or micro economic decision making, they only distort the prices of financial assets. This is where we find ourselves presently.
- Investors behave irrationally - there is no "risk free" rate, but we associate risk premiums as a spread over the risk free rate.
- The risk "markup" is disproportionately biased downwards based on a cognitive error called base rate neglect. For our purposes, this means that the true level of risk is ignored or biased downwards due to artificially low interest rates. (e.g., in the past, one may have demanded a 5% premium, but with rates at -.002, such a markup seems a bit excessive…)
- As rates fall below the rationality threshold, the suppressed risk premium results in a "search for yield," which drives gains in other assets like equities and structured products (MLPs as an example).
- When rates persist below the threshold, investors begin to neglect the basic tenets of time value of money - the discount factor is so close to 1 that calculating a present value doesn't seem to be needed. And while such dysfunction results in only a small valuation error, the failure to exercise rigorous financial calculations implies carelessness with respect to risk measurement.
- Cash eventually becomes a liability, not an asset - negative rates for savers, but positive spreads paid on central bank reserves. It's no wonder corporate controllers are raising as much debt as possible to pursue stock buybacks. The cost of debt is lower than their dividends, and holding cash on their balance sheets would wreck financial performance metrics such as Return on Assets.
- When the interest rate regime has rates above the threshold, a reduction in rates stimulates demand for credit.
- Investors behave rationally, money has a time value, cash is an asset.
- Investable fixed income alternatives to the equity markets provide sufficient yields to construct income ladders that can provide retirement cash flows.
- Investing decisions return to sanity, and involve discounting cash flows and risk adjustment.
Option Theory and Time to Expiration
Option theory can be applied to evaluate the current interest rate progression relative to the rationality threshold. In this case, let's consider the monetary policy decision to normalize interest rates as the equivalent of the expiration of the option. The "strike price" for the option can be viewed as the rationality threshold, discussed above. The option comes into the money when the market interest rate meets the threshold rate. In short:
- Time to Expiry = Amount of time from today until monetary policy accommodation ends.
- Strike Price = Threshold rate, above which, financial decision-making is rational.
- Implied Volatility = Uncertainty surrounding the timing of the interest rate regime change.
- Initial Price = Current market interest rate (we can generalize and refer to the entire yield curve).
The purpose of referring to option theory is not to derive the price of this option, but rather to use the framework for evaluating the impact of the shrinking of the time to expiry and the movement of the initial price towards its strike price (as defined above).
Increased Price Volatility
As the time to expiry approaches, the option's sensitivity to changes in the underlying will be exaggerated, primarily because there's not a lot of time left for the underlying to move back towards the strike price (compared to a longer dated option). Conceptually, this can be used to explain why we have seen such a marked increase in volatility as the perceived timing of the interest rate regime change comes to the fore (and becomes perceived as imminent). Following are some diagrams from Martin Haugh, which illustrate the concept.
Notice on the graphs that the red lines illustrate increased price sensitivity as compared to the blue and green lines, which correspond to longer dated options (T is greater). In plain English, this means that the markets can be expected to demonstrate increasing sensitivity to rate changes as the end of policy accommodation approaches.
Again, we're using the option model to provide a conceptual justification for the increased price volatility seen in the financial markets, we're not deriving a price of that option. Rather, we're using that option's price sensitivity as a proxy for financial market price volatility.
Using option theory, it becomes logical and predictable that price sensitivity (and, by extension, financial market volatility) will increase as we approach the end of the rate regime and as rates move towards the rationality threshold. Moreover, one can predict that the price volatility will not only persist, but it will continue to increase as the option moves to expiry and as the rates move towards the strike price. Note that the price volatility will NOT be assuaged by better and clearer communication from the Fed. The markets are not really reacting to the uncertainty of whether the rate regime will shift, they are reacting to the uncertainty of the time to expiry. In other words, the Federal Reserve can use communication tools to help market participants gauge the true time to expiry, but as we approach that expiry (and as the rates move back towards the rationality threshold), volatility will increase regardless of the clarity of communication.
This might be one of the most hostile investment climates in which to retire in two generations. The inability to generate current income and the elevated equity markets imply that the risk profile for a balanced portfolio are most likely out of bounds for most risk appetites, and the income streams are most likely insufficient to provide an adequate lifestyle. Our predecessor generation struggled with high inflation as an incipient threat to their retirement income flows, while this retiring generation is faced with meager cash flows and an erosion of capital from severe market dislocation.
Those voluntarily seeking to retire might be persuaded to "stick it out" for another year, and choose a retirement date that is less hostile to savers. For those who have no choice but to retire, the most likely conclusion will be to keep short-dated fixed income ladders and hold onto a larger share of cash than would otherwise be the case.
Sooner or later, there must be a re-pricing of the discount rates and risk premiums associated with financial investments. The Fed has clearly stated that they are removing policy accommodation, and one can expect rates to begin to reflect economic reality. So, while a "wait-and-see" investment decision is guaranteed to provide miserable returns, it will help the investor avoid the likely disappointment that would follow, as the behaviors of market participants re-calibrate to the expiry of the rationality option.
For the past few months, the equity markets have entered a range-bound period with episodes of elevated volatility. The volatility will continue to increase as the timing of the interest rate regime shift is defined, and it will increase further as rates move towards the strike price (NYSEARCA:SPY).
Rates have continued to provide inadequate income despite the recent gyrations in the government bond markets where the yields recently backed up, resulting in substantial MTM losses for holders of long-dated instruments. Current income streams from short-dated fixed income are lousy, but going longer on the curve might be hazardous to a retiree's happiness, especially when rates move back towards reasonable levels. Imagine the frustrated retiree who sees others earning more on their 5- or 10-year bonds.
Source: Board of Governors of the Federal Reserve System (US), 10-Year Treasury Constant Maturity Rate [WGS10YR], retrieved from FRED, Federal Reserve Bank of St. Louis, May 16, 2015.
Corporate debt hasn't been much better. The following illustrates that corporate spreads continue to provide barely sufficient compensation to cover the associated credit risks.
Source: BofA Merrill Lynch, BofA Merrill Lynch US High Yield Master II Option-Adjusted Spread© [BAMLH0A0HYM2], retrieved from FRED, Federal Reserve Bank of St. Louis, May 16, 2015.
This article posits that option theory can be applied to evaluate recent market volatility associated with the end of monetary policy accommodation. The upward shift in rates towards this rationality threshold, where financial decisions once again discount the time value of money and the price of risk, will be messy. The change in rates be paired with financial market volatility, and it will be a challenging period for financial investors.
As central bank monetary policy normalizes, financial market price volatility will increase. Janet Yellen mentioned as much in her less-scripted remarks on May 6, 2015. A link is provided here. It is instructive to listen to the audio of the response that she gave - listen to it a couple of times, take notes.
Once the termination of the below-market rate regime has a defined end date, one can expect INCREASED price sensitivity, and by extension financial market volatility, associated with rate movements in a period of reduced time to expiry.
From a retirement planning perspective, this article suggests that it may be worthwhile to hold off on getting fully invested in long-dated financial assets until such time as the rationality threshold is met or exceeded.
Disclosure: The author is short SPY.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article is not intended as retirement or investment advice. It is intended for educational purposes, and illustrates the application of theory to investment ideas.