Predicting Interest Rates
Key Takeways
The outlook on interest rates have changed drastically from the start of the year from now. Predictions made by the banks and financial institutions at the beginning of the year are looking precarious now.
Many advocated for holding of bonds over equities due to how interest rates were expected to move. So far, equities have far outperformed bonds.
Even if you were to accurately predict the direction of future interest rates, the 2023 rate hikes showed that changes in interest rates affect the yields of bonds with different maturities differently.
All in all, whether it’s stocks or bonds, it’s best not to rely on short-term forecasts to make investment decisions.
One can’t predict the weather more than a few days in advance.
— Stephen Hawking
If you had been in Singapore over the past few weeks you would have been hit by not only a a heatwave but also sudden bouts of extremely heavy downpour. Many have had trouble deciding on whether it will a good day for outdoor activities or hiding at home. In the same way, it is very difficult to predict what markets will do tomorrow, let alone one year down the road.
At the beginning of the year, the bulk of investment outlooks by major banks and investment institutions expected a range of rate cuts for 2024. The natural conclusion to this was that bonds were a great investment opportunity as you could get both a higher yield and a capital gain. In addition, fund manager positioning showed that an overwhelming number were extremely overweight bonds and very underweight in equities.
The CME FedWatch Tool shows what investors were predicting with their interest rate expectations; as recently as 1 month ago, more than 20% expected some form of rate cuts as early as May this year.
However, that has quickly fallen by the wayside as you can see the current probabilities have all but concluded that there is unlikely to be any cut at all. This arose after the recent April inflation report which reported a surprising uptick in inflation numbers — something that very few expected.
During this short period, stocks have opened up a +10% gap from bonds. Can this continue or would it reverse? Hopefully you realise that your guess is as good as ours.
It is a common perception that as interest rates fall, bonds would do well, and vice versa. As a result, you would definitely be tempted to make duration decisions with your bond allocations because the simple assumption is that interest rates will follow central bank rate movements.
However, it’s not a given that bonds (or the whole yield curve for that matter) will move consistently with any Fed rate cuts. The interest rate environment in 2023 is a good example. At the start of the year, most investors were expecting rate hikes before year-end. These hikes eventually came — with four increases totalling 1% by August. But depending on what maturity of bond you were holding, your outcome could be extremely different.
The chart above showed what happened in the yields of different maturities of bonds throughout 2023. Remember that when yields rise, bond prices go down and vice versa. So in 2023, the US Fed hiked rates 4 times for a total of 1%;
Short duration bonds of 1 year or less had the biggest move in yields — rising from 4.5% to nearly 5.5% on average. This was in line with what the Fed did.
Bonds of maturities between 1 to 5 years saw their yields drop around 0.25%.
Bonds of maturities between 10 to 30 years saw their yields rise around 0.25%.
There was no consistent or clear pattern to how bonds moved despite rates rising. So for 2024, even if central banks decide to cut rates, would you be able to know which bonds would do well and which ones wouldn’t? It stands to reason it’ll be equally tough to guess.
Whilst bonds are affected by interest rates, there are many other factors and events outside of central bank activity that affect bond prices and yields as well. Bonds are affected by inflation, default risk, credit risk, prepayment risk, reinvestment risk, amongst many others.
That’s why interest rate predictions are so challenging. Rather than attempting to time these changes, you are better served making bond allocation decisions based on long-term goals rather than short-term predictions. So if you have a long term investment plan set out — holding some longer maturity bonds within your portfolio could be beneficial for various purposes. As long as that long term goal has not changed, then it is not useful for you to suddenly switch or change your bond allocation. Bonds also serve the purpose of buffering your portfolio from volatility, so changing your fixed income constituents can alter its purpose.
If you want to find out more about how to properly allocate between equity and fixed income in your portfolio, come and have a chat with us.
