There are some moments that mark your life, moments when you realize nothing will ever be the same. And time is divided into two parts, before this and after this. – John Hobbes (Fallen)
In the summer of 1977, my mother, brother, and I made our much-anticipated annual trip from our small East Texas hometown to the Dallas-Fort Worth Metroplex to visit my aunt and uncle. The big city offered us the opportunity to see and do things that weren't normally options at home, but the highlight was always a visit to our version of the happiest place in Texas (sorry Walt), the Six Flags Over Texas amusement park.
On the morning after Six Flags, I heard my aunt and mother discussing what we were going to do for the remainder of our stay. The plan for that day was to head to the shopping mall to buy back-to-school clothes for me and my brother. Coming from a small town with only a couple of department stores to choose from, the idea of literally having dozens of places to shop for deals under one roof was exciting…. for the adults.
My brother and I, however, weren’t eager to spend the day trying on new shoes and blue jeans. My aunt, noting our lack of enthusiasm, pulled out the newspaper and suggested we pick a movie to go watch at the mall theater. I recall that the listings took up an entire page of the paper. In the middle of the page there was an advertisement that included the image of what looked like a dark robot wearing a gas mask and German storm trooper helmet.
We had no idea what Star Wars Episode IV: A New Hope was about, but Mom thought Smokey and the Bandit may be a bit racy for my 7 year old brother. That narrowed our choices to Benji, Herbie, or the cool looking "robot". Little did we know that after the trip to the mall that day that nothing would ever be the same.
In the days before VCRs, DVR's, and Netflix, the movie experience was more than an activity, it was an event. Star Wars was one of only 54 movie releases in 1977 per the movie data website, The Numbers®. Compare that to this year, where 83 movies were released, in JANUARY.
Watching a movie today is almost as routine as watching reruns of The Brady Bunch was not so long ago. Now, with so many more flicks to choose from coupled with the ability to stream just about any of them through our home theaters or various other devices, it’s not that unusual to realize that you've already seen a movie after the first scene or two.
This week, that familiar feeling came over me while watching a business channel. The headline flashed that the Fed had “surprised” markets by raising rates for just the second time in a decade, boosting the rate that banks can lend each other money overnight from .5% to .75%. The stock markets soon lost about 2% of their value, mostly attributed to the rate increase.
There were plenty of commentators predicting the calamity that would result from this “unexpected” increase in rates. Then I realized why it felt like Déjà vu when I looked back at the Accountable Update I wrote about this time last year. In the 12/18/15 installment titled Staying Out of Trouble, I noted that the Fed had just raised fed funds rate by .25% and that they anticipated additional moves by up to 1% in 2016. Sound familiar?
The same people on the business channel were saying the exact same things they said last year, “Get out of bonds! Buy a house now before higher rates make them unaffordable! Don’t invest your cash, wait for higher rates! This is the beginning of the end! Buy gold before it’s too late!”
Eventually, the broken clocks will be right, for a moment. We prefer to have a plan for each of our clients that relies on evidence instead of guesses. The odds are this isn’t a defining moment that we will look back upon one day. It’s much more likely that this is just another movie that we’ve seen before. If you would appreciate a more in-depth look at some of the evidence, please enjoy the following Issue Brief from DFA’s, Doug Longo.
If not, head to the mall. There are only 9 shopping days until Christmas!
The Fed, Yields, and Expected Returns
Doug Longo
Dimensional Fund Advisors
Fixed Income Investment Strategist
December 2016
In liquid and competitive markets, current interest rates represent the expected probability of all foreseeable actions by the Fed and other market forces.
On December 14, 2016, the Federal Open Market Committee (Fed) concluded its final meeting for the year and announced its decision to raise the federal funds target rate from its range of 0.25%–0.50% to 0.50%–0.75%.
As we have mentioned before, Fed watching is a favorite pastime for many market participants who often presume that Fed actions will lead to specific market outcomes. On December 16, 2015, the Fed raised the federal funds target rate for the first time since 2006. As a result, some market commentators believed this was a signal that multiple rate increases would occur in 2016.
As we now know, the Fed failed to prove the market prognosticators right; the Fed did not change the target rate until its last meeting of the year. Despite this, interest rates in the US have varied throughout the year. In fact, as shown in Exhibit 1, immediately following the Fed’s rate increase in 2015, yields on many US treasury bonds decreased until the second half of 2016.
Exhibit 1. US Treasury Yields (%) as of December 14, 2016
Securities data provided by Bloomberg Barclays LIVE. Bloomberg Barclays data provided by Bloomberg.
Because interest rates in the US began to increase at the beginning of the fourth quarter, it prompts a question: Did the market lead the Fed to raise its key interest rate, or did the Fed lead interest rates higher by setting expectations?
Trying to answer the question may be futile, however. In liquid and competitive markets such as the US Treasury market, current interest rates represent the expected probability of all foreseeable actions by the Fed and other market forces. Market participants, using publicly available information, estimate the probabilities of different outcomes. Those expectations are collectively reflected in current interest rates. As publicly available information changes, market participants adjust their expectations, which are immediately reflected in new interest rates.
While market participants use publicly available information to set expectations, unanticipated future events or surprises relative to those expectations may trigger interest rate changes in the future. The nature of those surprises cannot be known by investors today. As a result, there has been no reliable way found to systematically benefit from trying to outguess market prices when forecasting changes in interest rates. We can say, however, that there is known and observable information in current interest rates, or bond prices, that we can use to set expectations about future returns.
The expected return of a bond can be decomposed into three components: (1) the yield of a bond over its holding period; (2) capital appreciation (or depreciation) of the bond due to the shape of the yield curve; (3) and changes in bond prices due to future changes in yields. As we mentioned earlier, there is no reliable way to predict future changes in yields due to unanticipated future events that are not yet known.
Our research and experience in the fixed income markets informs us that there is reliable information in the first two components of expected return that enables us to use current bond prices to identify securities with higher expected returns.
As we can observe in Exhibit 2, yields on US Treasury bonds have increased since the end of September. While the increase in yields has had a negative impact on fixed income returns over the short term, the expected returns of fixed income securities, as observed through the first two components of expected return, have increased.
The first component (yield) has increased as bond prices have decreased. Additionally, as yields on longer-term bonds have increased more, relative to shorter-term bonds, the shape of the yield curve has become steeper. A steeper yield curve increases the second component of expected return (capital gain). As time passes, a bond’s maturity and yield decrease as the bond becomes a shorter-term bond. On an upward sloping yield curve, this results in capital appreciation. As a result, the expected capital gain is greater for bonds on steeper yield curves if those bonds are sold before maturity.
We believe using information about expected returns in current prices combined with a long-term focus can serve investors well when pursuing investment goals. So while yields have increased over the fourth quarter, prices today indicate that forward looking expected returns have also increased.[1]
Exhibit 2. US Treasury Yields (%) as of December 14, 2016
Source: US Department of the Treasury.
[1] Fixed income securities are subject to increased loss of principal during periods of rising interest rates and may be subject to various other risks, including changes in credit quality, liquidity, prepayments, and other factors. Sector-specific investments can increase these risks.
Dimensional Fund Advisors LP ("Dimensional") is an investment advisor registered with the Securities and Exchange Commission.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. This content is provided for informational purposes, and it is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services.