This weekly commentary can be downloaded as a PDF here.
According to 30-Day Fed Funds futures prices, the implied probability of a 25bp hike occurring in September has eeked over 50%. So in trying to get out in front of this hike, the market seems to have gone ahead and caused the hike on its own.
Okay, okay – so increasing Treasury yields and a Fed rate hike aren’t quite – or really, at all – the same. But participants on the long-end of the curve, where rates have climbed 100bp since early February lows, seem to have decided that they’re done playing their game of musical chairs and have just walked out.
I would argue that the dynamics driving the long end of the curve were based on (1) the behavior of yield chasers willing to take duration risk and (2) momentum investors chasing declining rates throughout 2014. But for those in category #1, when you’re only getting a marginally better yield on 20-years versus 7- or 10-years, you have to begin wondering if the juice is worth the squeeze.
On 1/2/2015, 20-year Treasuries only offered an extra 29bp of yield over 10-years, but came with ~7 extra units of duration. In other words, buying the 20s instead of the 10s meant you were willing to take 1 extra unit of duration risk for each 4bp of extra yield. In my opinion, at that point you’re picking up excess yield pennies in front of a steam-roller known as a Fed rate hike.
And so it seems the yield chasers headed for the doors, which sent the momentum traders scrambling to close their positions – and hence a dramatic spike in rates at the far end of the curve.
So that’s the long end. But we’ve even seen some significant increases on the short-end of the curve, with 2-year rates climbing 25bp.
Which makes us ask the impossible to answer, but fun to guess, question of “what’s priced in?” Will anything even budge above the 2-years if the Fed hike happened tomorrow?
I’ll tell you what’s certainly not priced in: the ability for investors to blow a situation way out of proportion, panic, and take the worst possible course of action.
In fact, writing this on Sunday evening, it seems to be happening in real-time with “concerns” about Greece. The EUR/USD is down to ~1.10 (ironic, as a cheap Euro is really only going to further help those German exporters) and S&P 500 futures are down 1.55%.
Put another way, the S&P 500 has lost $306 billion in value over a country whose GDP represents 0.39% of the world economy. In dollar figures, Greece’s $241.72 billion GDP is smaller than the GDP of Boston, MA.
Last week we touched upon the benefits of ignoring the news. But for those times when you just can’t turn away the second best thing to have is diversification.
But where can we turn if both stocks and bonds are getting thwacked? It might be time to reconsider liquid alternatives.
You’d be forgiven if you gave up on liquid alternatives some time ago. According the Newedge, managed futures, as a category, recently went through a 3.5-year drawdown.
That’s tough for any investor to hold through, especially since liquid alternatives tend to be on the more expensive end of the investment spectrum.
But the one thing we can’t say is that the returns weren’t uncorrelated! Which is, ideally, what we’re looking for with a play into alternatives. Of course we want uncorrelated and positive expected returns, but if we’re long-term investors, we have to be willing to accept short-term underperformance. After all, even value investing can go a decade underperforming the broad markets.
Looking at the current broad list of liquid alternative ETFs – which cover multi-strategy, managed futures, event-driven, multi-currency, equity long/short, and others – there are a variety of positions that offer diversified returns from traditional fixed-income investments.
In fact, only the anti-beta long/short ETF “BTAL” offered any significant positive correlation. The remainder of the alternatives are positions that can be used to diversify – or potentially even hedge – a fixed-income position.
Investors should beware, however, that diving into the realm of alternatives that are negatively correlated to bonds may be trading one risk for another. In fact, many alternatives are negatively correlated with bonds because they are positively correlated with stocks.
For example, the hedge fund beta replicators like HDG and QAI use positions in broad equity markets. So, as always with alternatives, caveat emptor: make sure you understand the risk factors underlying an alternatives strategy.
But if you’re willing to dig, there are several plays that are uncorrelated with both stocks and bonds, including managed futures, equity long/shorts, multi-currency, and even some multi-strategy.
In our Dynamic Alternatives portfolio, we take advantage of many of these ETFs, including HDG, LALT, MNA, RALS, BTAL, and WDTI. We believe that in combining many of those positions together, we can create a stable absolute-return core that can serve to diversify both stocks and bonds.
Alternatives can be tough to hold – especially when it seems like diversification has been a total waste in the last 5 years. But with uncertainty in both stocks and bonds, alternatives may be able to help smooth the ride.
In Our Portfolios
We made significant changes to our Multi-Asset Income portfolio this week, eliminating remaining exposures to international dividends, mortgage REITs, long-dated Treasuries, and U.S. REITs.
Remaining in the portfolio are those securities less sensitive to interest rate changes, including bank loans, preferreds, convertibles, S&P buy-write, international REITs, emerging market debt, and U.S. dividend stocks. While we believe the recent portfolio shifts have helped reduce exposure to interest rate changes, they have also reduced our forward expected yield to ~5%.
Finally, since our Multi-Asset Income portfolio is a significant sleeve within our Tailwinds Suite, our Tailwinds Conservative portfolio was also updated this week to reflect these changes.