A few months ago I posted a piece that highlighted the difference between the hedgehogs and foxes of the investing world. It is still a cult hit amongst animal lovers cruising for pictures of hedgehogs. But the key point was that there are two different kind of investors. There are foxes who chase every bit of news in the hopes of outwitting the market in the near term, and hedgehogs, who have one big idea that if correct will more than compensate for the lack of near term detailed information. In the animal world, the hedgehog’s big idea is that no predator, howsoever hungry, wants a mouthful of quills.
The hedgehog-ish investing idea I posted on back in June was that investments made at low prices tend to result in superior returns. To this rather simple insight, I add a corollary: investments acquired at high prices tend to result in inferior returns. It is this second point that I comment on today. I sit as a prickly hedgehog type observing the big bubble of our era – the bond market – and ask myself, what can possibly stop long-term interest rates rising?
Figure 1: The Sun Rises over
The Interest Rate Cycle
Changes in the 10-year Treasury yield have been the pre-eminent driver of our economic lives. What has the trend been in Canadian interest rates, Swiss equity multiples,
The most telling picture with respect to the rate cycle is the 50-year chart depicting the yield-to-maturity of the 10-year US Treasury bond (arguably the world’s most important interest rate). Here we observe a parabolic increase in rates that started gently in the 1960’s and culminated with spikes in the early 1980’s. This uptrend was followed by a rapid decline in rates that began during the early years of the Reagan presidency and continued with a moderating decline to December 2008, where a low of 2.1% was hit in aftermath of the Lehman collapse.
Figure 2:
I offer a few observations on this chart above. First, it appears to the hedgehog in me that there is not very much room on the chart for rates to continue to fall towards the x-axis. If I knew nothing about the fundamental drivers of government borrowing costs (OK – I hear you, but I can’t stop now) then I would be inclined to believe that mere mean reversion might apply. And mean reversion would suggest that over the next several years the
The second observation I make is more technical in nature. If you look very closely, one can see that the trendline over the past five years is essentially flat. The great James Grant, whom I would follow into battle even if he were wrong just because he is such a great read, emphatically called a bottom on this curve in 2003 when the 10-year yield hit 3.1%. Clearly he was wrong. But a good market – and US treasuries were a good market – often gives you a long time to get out. Let me follow up Mr. Grant by calling the post-Lehman 2.1% yield the second part of the yield curve’s “double bottom.”
The third observation is more fundamental in nature. I am at a loss to explain why government bond prices are so high when the likelihood of eventual repayment (in real inflation-adjusted value terms) has rarely been as low. The internet offers no shortage of treatises on the unsustainable debt of the
Figure 3:
|
Date |
Yield to Maturity |
|
Jan 1, 1960 |
4.72% |
|
Jan 1, 1970 |
7.08% |
|
Jan 1, 1980 |
12.64% |
|
Jan 1, 1990 |
8.65% |
|
Jan 1, 2000 |
6.02% |
|
Jan 1, 2010 |
3.81% |
|
Average during period |
6.78% |
Practically speaking, central bankers are equipped with the full policy arsenal available to a modern state. Therefore, I doubt we will soon fall into a real take-to-the-streets economic crisis. But playing Ben Bernanke’s role looks to me like trying to win a chess game against Bobby Fisher with only king and a pawn at one’s disposal. We know what the outcome will be – rates will rise – the only question is when?
Investing Themes for Rising Rates
And what do we do as rates rise? A rising interest rate environment is a different kind of investing landscape, but one with many identifiable opportunities that investors can exploit.
The first opportunity arises from the increased volatility that occurs in a rising rate environment. The debts that get piled up when interest rates are low are harder for companies and their customers to bear when rates turn the other way. For this reason it is worthwhile opening up long/short and option eligible accounts and being prepared to take significant short positions following rallies such as the one which has lasted from March to December of 2009.
The second opportunity is in long-term ownership of asset classes which perform well in a rising interest rate environment. I have noted silver as a particular favourite, but commodities as a group possess characteristics which make them resilient in such circumstances. Growth-type equities which, like commodities, are not valued off current yields should outperform equity indices now dominated by dividend payers. I would not buy too many now, but these might be great investments to make in moments of turmoil.
Another successful strategy for a world with rising rates has simply been rolling over short-term deposits. Remember, to win in investing, you don’t need to put up big numbers if others are making losses. Short term paper will outperform long-bonds in a rising rate world and will also provide the flexibility with which to buy assets at opportune moments.
I recognize that the foregoing list contains very few of the well-loved and traditional components of most investor portfolios. But in investing there are no permanent friends or enemies, just a persistent imperative to grow capital. The music of interest rates appears to be changing. Therefore, it is time for all good hedgehogs to adjust their dance steps.
Great blog Geoff!
Just wondering why you think commodities/silver is a good investment in that environment considering the fact that high rates mean higher carrying costs for commodities
Posted by: D | January 19, 2010 at 09:03 AM