Since the financial crisis in 2008, markets have been buoyed by the supportive monetary policies of central banks. Investors have generally enjoyed a series of positive return cycles over the past few years – not unlike the relatively smooth ride on a merry-go-round. In 2015, however, the ride is likely to become bumpy, even disorienting.
While near-zero interest rates have made traditional “safe” allocations such as money market funds and Treasury bills relatively unattractive, investors have been able to reach for yields greater than 0% without experiencing significant volatility. However, as we embark on a cycle of higher rates, investors need to consider not only the yield of their cash alternatives, but also the prospect that these higher-yielding securities could encounter price volatility and reduced liquidity.
In particular, investment managers who focus on the front end of the yield curve will need macroeconomic forecasting acumen and fundamental economic research to correctly evaluate investments that seek to preserve investor capital. For investors, the time has arrived to plan for a new economic landscape.
Time to wake up
If you have been lulled to sleep on the easy merry-go-round, it's time to wake up. Complacent front-end investing should end now.
In 2014, many investors fearful of higher rates de-risked their portfolios by moving into shorter-duration passive strategies. While an outright reduction in duration may help to protect portfolios from capital losses associated with rising rates, there are periods when this simply does not provide enough protection. In 2014 alone, investors steered almost $16 billion to passive short-duration strategies (see Figure 1). But the potential for capital preservation derived from these strategies may face challenges. Why?
For one, passive benchmarks in the front end are generally in the direct path of rate hikes by the Federal Open Market Committee (FOMC); they lack the ability to steer clear of rate recalibrations. In fact, these shorter-duration passive and indexed strategies could backfire: If investors seek to “de-risk,” or reduce their duration exposure by allocating to these strategies, they are potentially heading directly into the volatility instead of avoiding it.
Two, strategies with pre-specified, structural interest rate exposure have little to no flexibility around their positioning, and may push investors into the heart of the proverbial storm. So even though investors may have chosen to reduce their aggregate interest rate exposure, they still have exposure to the precise location where rates may be most volatile.
Instead of simply stepping off and carefully exiting the merry-go-round when it slows, they may instead be jumping off when it is moving at full speed.
What to expect from the Fed
PIMCO’s short-term desk has high conviction that the Federal Reserve will raise rates this year as economic data improve. Our base case is that the Fed’s first rate hike will come sometime between June and September 2015. Economic data will likely show upward pressures on wages, while lower oil prices will support and spur consumer spending, consistent with our expectation of U.S. GDP growth of 2.75%–3.25%.
Importantly, however, the sequence of rate hikes in 2015 will not necessarily follow the same patterns as past hiking cycles, including 2004. The Fed may take a slow and measured approach this time around, and rates may ultimately peak at levels well below their cyclical highs of the past few decades.
As we approach this period of tightening, our team remains focused on two dynamics:
- First, for front-end investors the market reaction to (positive) economic data will be just as important as the data itself. The “taper tantrum” of mid-2013 showed how the markets can react dramatically to changing economic conditions and updated policy rate forecasts. Increased volatility also would undoubtedly unsettle some investors, while creating opportunities for others.
- Second, a FOMC rate hike directly affects front-end yields. The zero- to 2-year segment of the yield curve would recalibrate upward very quickly once the Fed makes clear it will hike the fed funds rate.
Regardless of the specific timing and magnitude of rate hikes, the implication is clear: After several years when rates did not rise as expected, investors will likely be forced to construct portfolios that seek to deliver attractive returns and downside protection amid volatility emanating from concerns over rising rates.
How PIMCO expects to navigate the front end
While challenging to certain strategies, rising rates can present opportunities, particularly for those with flexibility to reposition to where they see value on the curve.
Many investors remove all duration from their portfolios by moving to a money market fund or bank deposits, but that may not be the best strategy. Although this preventive action may reduce one’s aggregate risk profile, it creates obstacles to generating even nominal positive returns. In addition, these two options will grow increasingly rare for larger investors as regulatory changes force providers, such as banks and 2a-7 money market funds in the U.S., to reduce their size and capabilities.
Others may invest in short duration, passive/indexed strategies to reduce interest rate exposure. This also may not be an optimal solution as these strategies cannot avoid – or are greatly restricted in their ability to avoid – areas on the yield curve that may be most vulnerable to an increase in policy rates.
Active strategies not constrained by benchmark limitations may be optimal for investors as they can seek to limit interest rate exposure. For instance, if we believe there is little value at a point on the Treasury curve, we can reduce our exposure at precisely that point on the maturity spectrum.
Since we are not forced to replicate exposures in a passive benchmark, our active short-duration strategies strive to identify value through tactical security selection. Supported by our internal fundamental credit research and structured credit analysts, PIMCO’s portfolio managers are able to buy assets that we believe represent compelling opportunities for optimal risk-adjusted total return. In addition, forward curves are priced on investor expectations of rates and may overshoot their terminal destination. To the extent we think the market is underappreciating the significance of economic data, we are able to recalibrate our positioning to take advantage of cheaper parts of the interest rate curve, in our effort to generate positive excess returns.
The other key consideration for investors will be sectors that offer a) improved return/volatility profiles and b) additional yield/carry as we look for opportunities to diversify away from the recalibration toward higher U.S. rates. This will likely mean emphasizing areas such as corporate credit, which offers a spread above Treasury yields and diversification potential. By overweighting front-end credit exposures, portfolios are aligned with our view that the U.S. economy will continue to improve over the near term, further supporting credit fundamentals.
We will also look to areas outside of the U.S. As central bank policies around the world are likely to diverge further, there are many second-order effects on both sovereign and corporate exposure. By relying upon our deep team of analysts located across the globe, we strive to anticipate and position for varying central bank policies.
In summary, actively managed short-term and low-duration strategies may provide an attractive ballast to portfolios that may have exposure to risk assets. PIMCO offers a wide range of solutions that address investors’ desire to limit volatility through an allocation to short-duration strategies. These solutions provide potential benefits as they rely and focus on:
- Macroeconomic influences and their impact on global rate policy;
- Active management of interest rate duration, specifically emphasizing precise yield curve positioning;
- Deep global teams focused on fundamental credit research;
- Dynamic liquidity management, serving as both a defensive buffer and offensive dry powder;
- A stable platform with a dedicated group of specialized portfolio managers with time-tested track records;
- Understanding of the regulatory and market changes that will affect cash management and capital preservation strategies over the next decade.
For nearly 30 years, PIMCO has provided our clients with a broad range of short-duration investment solutions. Our deep and stable short-duration portfolio management team combines our top-down macroeconomic views with optimal risk-adjusted bottom-up tactical strategies to provide clients with solutions focused on capital preservation, liquidity management and performance potential. As we approach inevitable changes in the investment landscape in 2015, we will continue to focus on protecting our clients’ assets and helping them exit the merry-go-round safely.