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Negative interest rates may seem about as far-fetched as it gets for the U.S. economy, but…maybe not? In an official Federal Reserve news release on January 28, Janet Yellen alerted banks to prepare for that very possibility.

Don’t hold your breath however – in our view, it is highly unlikely that the U.S. would end up resorting to such an action. In theory, implementing negative interest rates are intended to encourage big banks to utilize idle cash reserves for lending and credit which, in turn, could lead to more fixed private investment and consumer spending to fuel economic activity and demand (as well as stoke inflation).

But, big banks don’t respond well to having their hands forced and would probably be more likely to hoard that cash or look to diversify into more risk assets, like foreign bonds. What banks want is a steep yield curve where fed funds rate borrowing is cheap and the 10-year Treasury trades at a premium. The Fed could actually, arguably, be selling bonds (to put downward pressure on price and upward pressure on yield) to accomplish that.

But, back to the notion of negative interest rates. While unlikely, what Yellen really wants is for banks to test their balance sheets and operations to see how they can, and would, cope with negative interest rates. Part of the Dodd-Frank Act requires the biggest banks to perform stress tests and, for the first time ever in 2016, the Fed's annual stress test will embrace a scenario where the interest rate on the three-month U.S. Treasury becomes, hypothetically, negative in Q2 of this year. The Fed has defended this move by saying that, in the event traditional policy measures cannot keep the world's biggest economy afloat during a financial crisis, this new policy move would give them another option to explore.

Bottom Line for Investors

The effectiveness of slightly negative interest rates is far from assured and experiments thus far in countries like Finland and Sweden haven’t delivered conclusive results. It probably wouldn’t matter anyway, as those countries bear virtually no resemblance to the complexities of the U.S. economy.

By and large, it is our view that negative interest rates are not only unnecessary to stimulate the U.S. economy (it’s growing just fine without them), they’re also undesirable. Markets would likely look upon them as a move of desperation and banks don’t want to feel trapped into lending. If more lending and better credit conditions are what the Fed and politicians want, they’ll probably have to resort to policy actions that are not popular in the current environment following the financial crisis. They’d have to create an environment where banks want to take more risk, meaning a reduction in some of the regulations associated with Dodd-Frank. Don’t count on that anytime soon. 

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High on the list of investor fears heading into 2016 is a “rising rate” environment. Déjà vu indeed. This has been a concern among investors for years now. With the Federal Reserve increasing interest rates this month for the first time since 2006, these fears have only been exacerbated.

When it comes to investing in bonds, are these fears warranted?

At first blush, they would seem to be. As bond prices move in the opposite direction to interest rates, rising rates can be a short-term headwind for bond returns. As we will soon see, though, the key to this sentence is short-term. Over longer-term time frames, it is the level of interest rates, not their direction, that is the most important driver of returns.

We have total return data on the Barclays Aggregate US Bond Index going back to 1976. Since then, bonds have experienced only 3 down years: 1994, 1999, and 2013. In each of these years interest rates rose: 239 basis points (2.39%) in 1994, 151 basis points in 1999, and 74 basis points in 2013.

(Note: the worst year for bonds was -2.92%, incredible when you consider that the fear of bonds today exceeds the fear of stocks).

While certainly a factor over a 1-year time frame, when we look at longer-term returns the direction of interest rates becomes less and less important. The most important driver of long-term bond returns is the beginning yield. Why? Simply stated: when bonds approach maturity, they move closer to their par value and the short-term gains or losses from interest rate moves disappear. What you are left with, then, is the compounded return from the starting yield and reinvestment of interest.

The relationship is immediately clear when viewing the chart below which displays starting yields by decile (lowest decile = lowest starting yield) and actual forward returns. The higher the starting yield, the higher the forward return and vice versa.

The close relationship between beginning yield and future return has persisted throughout time. While rising rates can be challenging for bond holders over short-term periods, they are a positive for investors over longer periods as interest payments and maturing bonds are reinvested at higher yields.

From 1977 through 1981, the yield on the Barclays Aggregate Bond Index rose each and every year, moving from 6.99% at the beginning of 1977 to 14.64% at the end of 1981. Over this 5-year period, bonds were still positive every year though performance was subpar. How was this possible? Again, the starting yield of 6.99% provided a cushion for returns as did the reinvestment of interest/principal at higher yields.

The short-term pain from the rise in yields from 1977-1981 would lead to long-term gains for bond investors. The next five years would witness the highest 5-year annualized return in history at nearly 20%. This was achieved due to high starting yields and a decline in rates over that subsequent period, with the beginning yield again being the most important factor.

No Pain, No Gain

As I wrote back in May (see “Bond Math and the Elephant in the Room”), bond investors today are faced with their most challenging environment in history. The low yields of today portend lower long-term returns. The only way out of this situation is pain, with rising rates leading to short-term losses but the promise of higher future returns. If investors were objective and rational, then, the greatest fear would not be “rising rates” but a continuation of the lowest yield environment in history. Or worse still, “falling rates” from here which would provide a short-term boost to returns only to guarantee even lower long-term performance.

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This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

CHARLIE BILELLO, CMT

Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of three award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors previously held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

They said the Fed couldn’t taper without massive market dislocations. They said the Fed was “trapped” and “backed into the corner” and “behind the curve” or that there no longer was a curve anyway – just endless helpings of stimulus and no benefit accruing to the economy whatsoever.

In the meantime, the FOMC has now removed itself from new bond-buying operations completely as its current portfolio begins to slowly wind itself down over time. Employment is strong and we’re starting to see quarterly GDP releases with a 4-handle in front of them. Inflationary pressures are nowhere on the horizon for the time being, with Bank of America Merrill Lynch’s economists saying the risk is lower, not higher, for prices throughout the economy. They see core PCE hovering around 1.4% next year with the risks being to the downside.

Ethan Harris writes about Yellen’s year-end victory and the three key things we can take away from the Fed’s final performance of 2014:

Turning to the Fed, we think the latest directive and press conference confirms three key calls. First, they would much rather go too late rather than too early. Hence Yellen acknowledged that they expect to slightly overshoot full employment and she all but ruled out a hike in January or March. Second, the Fed is getting increasingly worried about missing the inflation target, but they are not ready to admit it; instead, they are “closely monitoring” inflation. Third, the Fed clearly wants to avoid shocking the markets. This is why Yellen has repeatedly downplayed shifts in forecasts and language. This talk therapy was taken to a new level this week when they substituted “patient” for “considerable time” and then said they mean the same thing!

All of this underscores a key aspect of Fed watching. Trying to forecast the exact language change in the FOMC directive is a bit of a fool’s errand. Instead, look for the Fed to change policy in a way that only slowly and modestly tightens financial conditions. By this metric, the latest meeting was a success: they got rid of “considerable time” with only a modest rise in interest rates and a surge in the stock market.

Over the last two days, since the Fed’s press conference, the S&P 500 has gained 4.5%. The Dow rallied over 400 points yesterday after a monster day on Wednesday. It was the biggest two-day rally for stocks since November 2011 at the end of the Euro Crisis panic.

Amazing how far we’ve come – disinflation being the bigger issue than jobs growth. In Janet Yellen’s mind, this has got to be a clear win.

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