Contradictory signals make forecasting interest rates tougher than ever. Here’s how three experts do it.
By Laurie Kaplan Singh
November 2001
Institutional Investor Magazine
The U.S. bond markets have been a haven in recent months for investors abandoning a sinking stock market. But after the September 11 terrorist attacks, bond investing has become much more of a challenge. Economic indicators are befuddlingly mixed. On the one hand, the Federal Reserve Board’s massive monetary stimulus and the prospect of heavy government borrowing suggest a future upsurge in inflation. On the other hand, the increasing likelihood of a global recession, a strong U.S. dollar and worldwide overcapacity point to deflation.
To make sense of conflicting omens, Institutional Investor spoke to three top interest rate watchers: Bill Tedford, director of fixed-income strategy for Little Rock, Arkansas-based Stephens Capital Management (a division of Stephens Inc.); Mark Lay, chairman and CEO of Pittsburgh-based MDL Capital Management; and Alan Kral, a principal at New York City-based Trevor Stewart Burton & Jacobsen. All three see interest rates declining, then rising, but to different degrees and for different reasons.
“The recent acceleration in the monetary base will put upward pressure on inflation and interest rates but not for about a year,” contends Stephens Capital’s Tedford. It typically takes about 21 months for stimulative monetary policies to show up in inflation numbers, and the bond market anticipates inflation well before that, he says. But he won’t speculate on how much lower. “Our methodology is designed to forecast the direction of a change in interest rates,” he explains, “not the magnitude of that change.”
MDL’s Lay is willing to quantify his forecast. “The yield on 30-year Treasuries will drop to about 5 percent by year-end as the yield curve flattens,” he says. He proved prescient, if unintentionally so, when on October 31 the Treasury announced that it would eliminate the 30-year bond, sending its yield down to 4.88 percent, its biggest single-day movement in a decade.
Trevor Stewart’s Kral also expects interest rates to decline in the face of economic weakness. “There’s little upward pressure on inflation because the global economy is still feeling the impact of the 1997 to 1998 capital crisis and is willing to sell goods below the cost of production.” Another factor that will push Treasury rates lower in the next few months, in his view, is the growing flight to quality in the bond market ever since September 11.
However, this downward trend will reverse in 2002, conclude all three forecasters. Interest rates will start to drift higher as the Fed’s aggressive stimulus package prompts fears of intensifying inflation. “The bond market already is anticipating a significant economic rebound sometime in 2002,” Lay says. “The market, in effect, is saying that the Fed is overdoing it.” Heightening the possibility of still more future inflation - and thus putting additional upward pressure on interest rates - is the prospect of heavy government spending on defense and infrastructure.
Yet Lay doesn’t foresee a prolonged upsurge in rates. “Inflationary expectations will drive interest rates up for a while,” Lay says, “but eventually, the fundamentals will prove those expectations unfounded. The world is flooded with overcapacity, and longer term this will lead to lower prices and deflation.”
Kral is less optimistic. He now thinks rising inflation is likely to be a long-term problem. “All of the raw material is in place to reverse the decline in inflation that we have seen over the past 20 years,” he says.
Low producer prices are masking increases in other inflation components, such as the price of pharmaceuticals, homes and services like medical care. Ultimately, Kral continues, there will be less produced, and producer prices will accordingly go up.
A war psychology could exacerbate the inflationary pressures. “In wartime, resources are allocated to nonproductive uses,” notes Kral.
Tedford foresees declining interest rates, at least over the next three months, and so has structured his bond portfolios for a bull market. The average maturity and duration are approximately seven and 4.95 years, respectively. But Tedford says it’s “very likely our portfolios will have the opposite posture one year from now.”
Among interest rate forecasters, Tedford is the ultimate minimalist. “We have studied this for many years, and there’s only one variable that drives the primary trend in interest rates, and that’s inflation,” he insists. So while many of his colleagues use sophisticated statistical analysis and modeling techniques to forecast a multitude of economic variables, Tedford uses a Microsoft Excel program to track what he considers the only important indicators of interest rate trends: the consumer price index, the monetary base and oil prices.
In keeping with his preference for simplicity, Tedford maintains a compact portfolio of approximately ten bonds. “In theory, you could accomplish the same objective with just two bonds,” he says. The fund, which is designed as a pure, intermediate-term interest rate play, buys only government and agency bonds with maturities of ten years or less. Historically, between 75 percent and 100 percent of its assets have been invested in U.S. Treasuries.
“We buy only noncallable paper,” Tedford says. The portfolio’s emphasis on government bonds keeps it virtually free of credit risk.
“It’s a basic, plain-vanilla strategy,” notes Tedford. Investors can’t complain. Over the ten years ended September 30, Stephens Capital Management’s intermediate bond strategy produced an average annual return of 9.03 percent (versus 8.56 percent for the Lehman Brothers government-intermediate index). With the notable exception of 1994, when Stephens’ portfolio lost 0.5 percent (versus a 1.7 percent decline in the index), Tedford’s strategy has produced consistently positive annual returns for nearly 13 straight years. For the year-to-date ended September 30, the portfolio, with approximately $300 million in assets, was up 9.03 percent (compared with 8.57 percent for the Lehman government-intermediate index).
Like Tedford, Lay and Kral believe that the direction and level of interest rates are primarily driven by the level of inflation. But to get a pulse on inflation, they and their colleagues analyze myriad economic factors, the most important being monetary and fiscal policies. “The actions of the Federal Reserve in providing liquidity are the single most important driver of future inflation,” says Lay.
Reflecting the firm’s outlook for a decline in long-term interest rates by year-end, MDL’s portfolios are currently positioned toward the longer end of its normal duration range of between three and seven years. Unlike Tedford, however, Lay and his colleagues don’t rely solely on their interest rate forecasts to construct their portfolios. They also consider the shape of the yield curve and the supply-and-demand dynamics of various bond sectors.
At the moment, Treasury bonds make up 60 percent of the portfolios’ assets, and mortgage-backed pass-throughs (Ginnie Maes and Fannie Maes) claim 35 percent. “Mortgage-backeds have become very cheap given the recent acceleration in prepayments,” Lay says. Besides, MDL tends to keep a sizable weighting in mortgage-backeds to maintain a resemblance to its benchmark, the Lehman aggregate bond index. The company invests the remaining 5 percent of its assets in corporate bonds rated A or better, which are offering attractive incremental yields, according to Lay.
MDL runs approximately $3.1 billion in fixed-income assets for institutions. Over the five years ended September 30, its flagship portfolio returned an average annual 8.91 percent, versus 8.06 percent for the Lehman aggregate index.
The average weighted duration of Trevor’s fixed-income assets (approximately $600 million) is now about five and a half years - slightly longer than the Lehman government/corporate bond index. The firm’s portfolios, which are tailored to clients’ risk guidelines, are normally fully invested in U.S. government bonds. But in light of the Fed’s monetary stimulus, Kral believes that the recent 30-to-40-basis-point widening of corporate bond yields over those of Treasuries is likely to soon reverse, as credit concerns over triple- and double-A-rated bonds abate. As a result, he is shifting a small portion of Trevor’s assets into investment-grade corporate bonds.
Kral won’t place more than 20 percent of his assets in corporates, and he’s only buying securities with good call protection. In a shifting market like this one, the prudent course is probably wise.
