Positioning for a falling interest rate environment

Introduction: Preparing for lower rates

Modern monetary policy is postulated on having low and stable inflation. Globally, many central banks have targeted a 2% year-on-year rise in CPI as the most appropriate to achieving their inflation goal while maintaining solid economic growth and low unemployment. Since the introduction of a 2% CPI target by the Royal Bank of New Zealand (RBNZ) in the early 1990s and its later wider adoption, central banks have sought to offset periods of high inflation by raising base interest rates, while subsequently cutting base rates as inflation returns to target.

Historical analysis suggests that cash and fixed income investors that maintain a short duration strategy during periods of rate hikes benefit from the ability to quickly reinvest at higher yields, and can later extend duration to lock in yields and benefit from capital gains as inflation normalizes and central banks pivot to cut base rates. However, during the current rate hiking cycle, stickier-than-expected inflation has kept base rates higher for longer–magnifying interest rate volatility, clouding potential pivot points and complicating investment strategies.

Nevertheless, there are several steps investors can take to prepare for a decline in interest rates while avoiding significant volatility and still benefiting from current elevated yields.

Drivers of return

Returning to the basic formula for calculating fixed income performance is a good starting point for considering the key drivers of return:

Fixed income return = (yield x holding period) – (change in yield x duration)

A liquidity investor may be able to generate higher returns by targeting higher yields, holding positions for a longer period, and—when rates are falling—choosing a strategy with a higher duration. Each of these strategies provides varying degrees of control:

• Duration: A liquidity investor has greater control over duration and can choose a deposit, a money market strategy, an ultrashort duration strategy, or a short duration strategy to express a duration view.
• Holding period: Liquidity investors can also control their holding period by segmenting their cash by liquidity needs. For cash that is subject to frequent and unpredictable drawdowns, a short holding period could be best. For stable cash that has infrequent and predictable drawdowns, a longer holding period is possible.
• Yield: A liquidity investor has only limited control over yields. Credit bonds have higher yields than government bonds. Long or shorter bonds may have higher yields depending on the yield curve shape. However, ultimately yields are market driven. Fortunately for investors today, yields are the highest they’ve been for front-end investors since before the global financial crisis.
• Changing yields: A liquidity investor has the least amount of control over the change in yields, which are driven by the economy and the markets. At this juncture, data-dependent central banks are focused on inflation and the labor market, as key drivers of monetary policy.

Positioning for uncertainty

As with any investment, to increase returns over time a portfolio must take risk. Adding duration increases the interest rate sensitivity of the portfolio—boosting returns when interest rates rally, but also detracting from portfolio returns when rates sell off. For liquidity investors, adding duration can be achieved by increasing the allocation to strategies with higher weighted average maturities (WAMs).

However, determining the appropriate level of interest rate risk is critical. To avoid excess volatility and minimize the risk of negative returns, we recommend targeting a duration no greater than the investment time horizon. For example, if there will be no need to withdraw cash from the portfolio for six months, then implementing a strategy with a duration of approximately half a year could be appropriate—this is the area where many ultra-short duration portfolios operate.

Higher duration portfolios are more sensitive to changes in interest rates. Their returns are more volatile, and they sometimes need a longer holding period to give them a chance to outperform lower duration portfolios.

Timing central banks

Returns will be higher if investors increase duration ahead of rate cuts. However, it is very difficult to time the market, especially in the current market environment where central banks have abandoned forward guidance and a clear policy framework in favor of data dependency. An effective strategy to avoid volatility could be to ladder the initial investment over a period of time to diversify the entry levels.

Data dependent central banks are currently focused on key inflation, labor market and financial condition metrics. While the quality and reliability of these data points is low and subject to multiple revisions, especially as structural economic change impacts historical economic relationships, their longer-term trend can signal potential inflection points in monetary policy. Notably in the current economic cycle, the forward curve and two-year/10-year Treasury spread have not been reliable predictors.

Conclusion

When central banks signal that base rates have peaked, markets can quickly pivot to price in expectations of interest rate cuts. However, predicting and timing a rate cutting cycle, along with its frequency and length is very challenging. 

Currently, cash investors can enjoy multi-decade high yields on their investments while strategically positioning for a subsequent decline in interest rates by adjusting the duration and liquidity of their portfolio based on their likely holding period and cashflow volatility. By utilizing the broad array of liquidity solutions from money market to ultra-short duration strategies, investors can maximize returns by positioning their cash to benefit from the likely decline in interest rates while minimizing volatility.