Tuesday, October 26, 2010

Outside the Flags: The Rate Show

Jim Parker, Vice President, DFA Australia Limited

Any financial editor knows interest rate forecasts always make popular articles. After all, so many people are sensitive to rates either as lenders or borrowers. If only they knew they don’t need a forecast to invest wisely.

With forecasting economists seeking publicity and the media wanting easy cut-and-paste coverage that keeps readers clicking through to see the ads, it’s easy to understand the demand for stories speculating on rate movements.

But what’s not often appreciated by the general public is that the wholesale bond market is usually two to three steps ahead of the official forecasters in pricing in expectations for what the central bank might do.

In viewing this phenomenon in action, Australia is a good example because the Reserve Bank here has moved ahead of the rest of the world in slowly moving up official cash rates from crisis levels closer to long-term averages.

The chart below compares benchmark short-term lending rates in Australia, the UK, Canada, the Euro area, Japan and the US over the last six years. As you can see, while rates in the other major developed economies have remained at 1 percent or lower, Australia’s cash rates have moved up from 3 to above 4 percent since late 2009 due to the relative strength of its economy.

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While the RBA kept its cash rate on hold throughout the June quarter after the last move in May, newspapers at time of writing were full of speculation about a possible resumption in this policy tightening program in November.

This speculation is good for circulation as it gives people the perception that by closely tracking the views of the market experts, they can manage their portfolios in a way to avoid the impact of the rate increases when they come.

The problem for the general audience is that all that information and commentary and analysis from the bank economists tends to be already reflected in prices. In other words, by the time you read about it, it’s old news for the market.

And even if you did get the “inside word” on anticipated interest rate moves, there is no guarantee that new events will not occur in the meantime to change the outlook yet again and leave your timing strategy in tatters.

Take, for instance, what happened in Australia in early October. The RBA took the market “by surprise” in not announcing a rate increase after its monthly policy meeting. The move had been seen as such a sure thing that one major national newspaper had the story pre-written and published on its website that the rate rise had, in fact, happened when it, in fact, hadn’t.1

The story quickly disappeared when an alert editor noticed the central bank’s website actually said rates had not changed, but some astute blogger was clever enough to take a screenshot before the evidence could be removed.

In late October, the Reserve Bank published minutes of that meeting, revealing that the decision had been “finely balanced”, but that the sudden surge in the Australian dollar in early October had been one consideration in waiting.2

Financial markets then began to speculate again on the likely next move. This chart of implied yields on 30-interbank cash rate futures – a proxy for official cash rate expectations – shows that as of late October the market was already priced for at least two further quarter percentage point rate rises over the coming year.

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This is not to suggest these priced-in increases are a done deal. But it serves to highlight that markets move very quickly in anticipating interest rate changes. Naturally, as new information comes to light, that pricing may change.

But the important point for the small investor is that the noise around interest rates in the media usually reflects expectations that are already in the price. It is incredibly difficult, without inside information, to second guess the market and forecast interest rate movements with any sustained accuracy.

This is why Dimensional does not try to play the forecasting game. Instead, it works with the opportunities in the yield curve as they present themselves day to day. When there is an opportunity for taking on more term risk (longer-dated bonds), the portfolio managers will do so. But when the yield curve is inverted (short-term interest rates are higher than longer term), they will move the strategies closer toward cash.

This is not a market timing approach. It is about taking on more term risk when there is an acceptable reward for doing so and winding back on term risk when expected returns from that risk factor are not so great.

In Dimensional’s newer US fixed interest strategies, it takes a similarly variable approach to credit risk, adopting greater risk when expected returns from lower-rated investment credits are high and winding back when anticipated rewards are low. As always, risk is controlled by very broad diversification.

So the bad news about interest rates and fixed interest investing is that there is no such thing as a crystal ball that works. The good news is that you don’t need one to invest successfully in this asset class.


1. Reserve Bank Lifts Interest Rates to 4.75pc, The Australian, Oct 5, 2010


2. Minutes of the Monetary Policy Meeting of the Reserve Bank of Australia Board, Oct 5, 2010