What to do when U.S. interest rates rise

Bubble angst is widespread. Some 80% of the bond portfolio managers queried by the Certified Financial Analyst Society of the U.K. in a mid-March survey agreed that bonds are overvalued. The timing of the Fed’s interest rate hike remains uncertain; among those surveyed, some say it will start in summer, while others say it will happen before the end of 2015.

The Fed’s timing is contingent upon its measures of business activity in the U.S. and, perhaps, what central bank estimates the effect would be on the global economy. The global investment community is trading on uncertainty regarding the timing of the inevitable. U.S. treasuries’ prices, rather than falling, rose to a six-week high in mid-March after Fed chairwoman Janet Yellen omitted the word “patient” in remarks about plans to raise rates. Traders parsed the absence of the word and, confident that a rate rise was not imminent, sent the yield on the bellwether 10-year treasury bonds down to 1.9%, the lowest level since early February.

Low inflation

The Fed may be asking, “What’s the hurry?” Inflation is low in the U.S. Energy prices, especially the cost of gasoline, have plummeted, leading to a decline of 0.1% in the U.S. consumer price index for the fiscal quarter ended Jan. 31, 2015. Unemployment fell to 5.5% as of March, down from an average of 6.2% in 2014. And the ascent of the U.S. dollar (US$) against other major currencies has meant that the prices of imported goods are dropping for American consumers.

Moreover, the momentum of the U.S. economic recovery is drawing capital to the U.S., pumping up the money supply, which eventually will feed inflation. Higher interest rates would exacerbate the problem, drawing even more cash to the U.S. There also is risk to the income of U.S. companies because 40% of their earnings come from other countries. Thus, a rise in the US$ reduces these companies’ profits and potentially could have grave effects on the capital markets.

“The risks of raising interest rates prematurely or being seen to raise them [by] too much could crash U.S. bond prices, increase mortgage costs and even pull down stocks,” says James Hymas, president of Hymas Investment Management Inc. in Toronto. “The Fed is riding a tiger, and knows it.”

Nevertheless, the global bond market has to normalize, says Jack Ablin, executive vice president and chief investment officer with BMO Harris Private Bank in Chicago. The 10-year U.S. Treasury bond should track the growth of nominal gross domestic product, now at 4.6%. The gap is 268 basis points (bps) – and it will close. If the Fed does not close it, the bond bubble and distortions of capital markets will continue.

Timing uncertain

Investing in inevitability ought to be a cinch, but it’s not. Not only is the Fed’s timing uncertain, but the BoC cannot synchronize moves with the Fed. There will be a lag before the BoC raises rates.

Charles Marleau, president and senior portfolio manager with Palos Management Inc. in Montreal, says his strategy is to sell U.S. Treasury bonds – on the theory that other traders will eventually do that – and to stick with Government of Canada bonds in the belief that the BoC will not follow the Fed for many months.

“It is more likely than not that the BoC will drop [interest rates], perhaps by 25 bps by yearend,” Marleau says. “That would give a boost to [Canadian] federal and provincial bonds. I want the pickup, and I think there’s no significant risk in the trade. Now that the U.S. economy is moving upward and U.S. unemployment numbers are down, there is much higher probability that U.S. interest rates will rise. Canada, for now, will continue to lag.”

Meanwhile, Marleau says, Canadian corporate bonds are not the place to be. His reason is that what happens in New York also will happen in Toronto; thus, he is bearish on taking advantage of spreads on corporate bonds. Marleau’s theory is that U.S. investors will dump U.S. corporates and that this will rub off on Canadian corporates.

Marleau’s strategy is to sell Canadian corporates across the board and buy provincials, for which there are a hefty spreads. For example, a Province of Alberta 1.25% bond due June 1, 2020, has recently been priced to yield 1.46% to maturity vs a Canada issue with a 1.5% coupon due March 1, 2020, which has recently been priced to yield 0.98% to maturity. That’s a 48-bps pickup for the provincial bond.

It all comes down to a question of balance. Beste Alpargun, vice president and portfolio manager with Seamark Asset Management Ltd. in Halifax, agrees that the BoC will stay put even if the Fed raises rates: “This is not Canada’s year for a hike.”

That implies safety in Canadian government bonds.

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