Introduction

Every week I try to take noteworthy events and provide accessible commentary regarding the potential impacts of these events and my own personal interpretation. These comments are not necessarily the viewpoint of Newfound Research and solely represent my own personal perspective.

Week Ending: May 31st, 2013

Rising Treasury Rates

The big news this week is the continued increase in treasury yields across the spectrum of maturities. Beginning the week preceding Ben Bernanke's testimony to congress on May 22nd, we've seen a precipitous climb in rates.

yields_increasing

Since May 16th, it may not seem as though a sizable increase in rates has taken place (take note of the scale of the left-axis). The low point on the chart, on May 2nd (for the 5 year rate) is 0.82% compared to a maximum just two days ago of 1.23% (again, for the 5 year rate) -- not even a full percentage point change. However, when examining yield based products, it's always important to consider the loss of principal that would result from a given change in yield, instead of the rate in isolation. Consider the estimated drawdown a fixed income investor has experienced for the different maturities over the same time horizon below.

treasury_drawdowns

This chart reflects that an investor in 5 year treasury zero coupon bonds would have experienced nearly a 2% loss in the month of May alone. For investors looking for a "risk-free" investment (as treasuries are often considered), that's a sizable loss.

Rationale for the Increase in Rates

One of the most challenging roles that some take on in capital markets is attempting to rationalize, and then corroborate with data, the "reason" something is taking place in the markets. Often the term "correlation does not imply causation" refers to the phenomenon where spurious statistical relationships are extracted from data, that doesn't necessarily support the conclusion that one phenomenon has caused another.

Regarding the increase in interest rates, I've encountered several articles that have attempted to "explain the increase in rates" visa vie a changing in expectations of future inflation. However, when you look at derived inflationary expectations using the yield in TIPS and maturity-equivalent Treasuries, you get declining expectations for inflation across the maturity spectrum, which is the opposite of what we'd expect given rising interest rates.

infl_decreasing

Other areas of fixed income have been hit hard as well, as evidenced by the performance of Emerging Market Debt, Investment Grade, and High Yield Fixed Income (note that as my prior blog post on lower credit in rising interest rates environments conjectured, lower credit was impacted the least in this rising interest rate environment).

bond_prices

However, it would be inaccurate to say that "all" areas of fixed income have declined, as High Yield Ex US and International Government Bonds have experienced a recent uptick in the past week.
rebound

Lastly, I think it's valuable to examine changes in total net assets in money markets over the same period.

money_mkt

Based on the graph above and the decline in many fixed income type investments (and some equity markets as well), it would appear that investors are taking profits and parking the liquidity until the direction of equity markets and bond markets can be more clearly understood.

Noteworthy Reads / Events of the Week

  • France's Continued Slow Decline: If you considered France as one of remaining countries in the Euro exhibiting financial stability, you may want to reconsider. Household Confidence plummeted to its lowest levels since data collection began (yes, lower than the trough of the Financial Crisis) and France's economy was one of six (the remaining being Spain, Belgium, the Netherlands, Poland, Portugal and Slovenia) given more time to reach a 3% target budgetary deficit. Specifically, France has been given 2 years to reduce its deficit from 3.9% to 2.8% in 2015.
  • Further Divergence between the US & Europe: The OECD came out with projections that US activity is projected to rise by 1.9% this year and by a further 2.8% in 2014, whereas Euro area GDP is expected to decline by 0.6% this year and then rebound by 1.1% in 2014.
  • Mortgage Loan Applications Decline in the Face of Rising Rates: The spikes in treasury yields have had significant impacts on the overall applications for mortgage loans. Total Mortgage applications have declined by 8.8%. Specifically, a 12.3% decline in the applications of refinancing and a 2.6% increase in home purchase applications.
  • Straight Shootin': No matter how minimal your time in the news and blog-sphere, you know how challenging it is to find a straightforward, unbiased perspective on QE. That's why I was pleasantly surprised to encounter this article on It's Not That Simple entitled, "QE: Because Nobody’s Got Any Better Ideas."
  • The Rising Rate Debate: There are differing perceptions on whether the current rise in treasury yields is temporary or is a warning sign of continued large increases.

Benjamin is a Managing Director in Newfound’s Product Development and Quantitative Strategies group, where he is responsible for the ongoing research and development of new intellectual property and strategies. Specifically, Benjamin’s focus is in the area of exploring model applications to fundamental, economic and systemic market variables. Drawing on his years of experience in the financial services industry, he helps to ensure that Newfound’s products and messaging effectively meet the needs of investors and portfolio managers. He also plays a critical role in developing new business and client relationships.