Waiting for Higher Yields? Pace Yourself.

By Jim Picerno, Director of Analytics

Savers who have been looking (hoping) for a yield boost have been disappointed for years. Recent comments by, Federal Reserve Chairman Jerome Powell suggest the wait will continue for the foreseeable future.

“We’re not even thinking about thinking about raising rates,” he said earlier this month in a video press conference. The comment followed the release of the Federal Reserve’s economic projections on June 10 – projections that revealed that the central bank’s target rate is expected to hold at the current 0%-to-0.25% range through 2022, based on the median forecast of Fed board members.

Investors looking to make the best of a low-rate environment have favored longer maturities, which offer higher rates than their shorter-term counterparts. But opportunity may be squeezed on this front in the near future. Powell hinted that the Fed is considering yield-curve control – a policy that puts a lid on Treasury yields for one or more maturities.

Some speculate that the Fed is already practicing yield control. Exhibit A is the 10-year Treasury yield, which has been holding in a tight range around the 0.7% mark since April. The fact that this benchmark rate, which is normally set by market conditions, hasn’t run higher at a time when the stock market has rebounded sharply has raised suspicions that the Fed is behind the stability.

If the worst of the coronavirus recession has passed and the green shoots of growth are emerging, the bond market should be pricing in the shift. For the moment, however, there’s no sign of recovery in the 10-year yield. Is this due solely to market conditions or is there a so-far unrecognized influence from the Fed? Perhaps Powell will clarify at the Fed’s next press conference in September.

What’s the sweet spot on the yield curve for hedging equity risk?

It’s long been accepted wisdom that bonds are an effective tool to offset downside equity risk. In turn, the stock-bond strategy is the core building block for risk management for portfolio strategy. But where on the Treasury yield curve is the maximum point of diversification benefit?

The answer isn’t obvious. As a first approximation, some investors might guess that longer maturities are uniformly better. True, but only up to a point. Going too far out on the curve is sub-optimal because while the price of a longer-dated Treasury will probably bounce higher than a shorter Treasury when stocks dive, longer maturities are also subject to greater risk when interest rates rise, even if only temporarily.

The goal for optimizing the choice of bond maturity is identifying the maturity that will deliver the best performance over a given time horizon while also providing the most diversification benefit vis-à-vis stocks. Quants spend a lot of time searching for this sweet spot, which evolves through time, but recent research from Pacific Investment Management Co. (PIMCO), the giant bond shop, finds that “on average, the ‘belly’ of the curve – around five years – maximizes the diversification benefit relative to a benchmark portfolio”.

A five-year maturity is not the best choice for every portfolio for every time period. To find the optimal maturity to match your portfolio’s profile you’ll need to spend time crunching the numbers. Meantime, the five-year note is a sensible estimate for a generic solution.

Calm before the storm?

US reported fatalities from the coronavirus continue to trend down, based on the daily change for data collected and published by Johns Hopkins University. According to these numbers, the pandemic peaked in America in early May. But a number of states are reporting that infections are rising, which raises questions about the possibility that a new wave of trouble is lurking in the weeks and months ahead.

Several states in the South and West are “on the cusp of losing control” with new infections, says Dr. Scott Gottlieb, a former Food and Drug Administration Commissioner. “The question is: ‘Can we keep this from getting out of control?’ This is a virus that wants to infect a very large portion of the population,” he warns, noting that Arizona, Texas, Florida and several other states are showing worrisome increases in new cases.

The good news: rising infections aren’t translating into a faster pace of fatalities, at least not yet. Will a higher number of infections lead to a ramp-up in the death rate? Or is a wider spread of Covid-19 infections no longer a direct trigger for a higher pace of deaths? Unclear at this point since the consensus on herd immunity and other factors for this disease remains a work in progress.

For now, the downside bias in the daily change in fatalities endures. If and when this trend reverses the shift would signal that the recent peak was only a temporary lull.

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