Once upon a time, the U.S. Federal Reserve and other central banks would try to control inflation by manipulating the overnight interest rate charged to institutions that needed quick, short-term cash. If inflation heated up they could raise the rate, thus reducing the amount of money in circulation and causing inflation to slow down. If the economy was struggling, they could lower the overnight rate to encourage more economic activity.
With the crisis of 2008, the Fed had to cut its overnight rate so far that it was effectively zero, and thus regulation of the money supply was no longer effective in stimulating economic growth. That’s when Fed Chairman Ben Bernanke came up with a new way to increase the amount of money in the markets. This was the concept of “quantitative easing”—the Fed would buy a “quantity” of bonds directly to increase the amount of money in circulation and “ease” the restrictions on capital.
Most (not all) economists feel this strategy was effective and successful for the US Bond Market, and as the economy improved the Fed talk turned to when and how the quantitative easing program would end. New Fed Chair Janet Yellen answered these questions early in 2014 when she announced the Fed would start to “taper” its loan purchases but on a very gradual schedule. As of May 2014 the purchases had been reduced from $85 billion to $45 billion a month.
So what does all this mean to the average investor and trader? Based on our patented supply and demand trading strategy at Online Trading Academy, we would assume with less liquidity (i.e. less money) in the marketplace the price of money (i.e. interest rates) will go up. So should you buy U.S. treasuries today as part of your wealth and income strategy?
If you’re looking for interest rates that will give you the kind of returns you can get in other financial markets, the answer is probably not. Those rates are still very low from a historical perspective; you’re not going to retire on a portfolio of bonds that pays 2.5% APR. Plus, when inflation returns and interest rates go up, the price of those fixed income assets will decline. That’s because other, newer bonds will be paying perhaps 3% compared to your 2.5% Treasury. If you should want somebody to take it off your hands then you’ll have to cut the price. (Of course, if you intend to just put the bond in a safe deposit box until maturity—like people used to do with U.S. Savings Bonds—then this strategy doesn’t matter.)
A safer strategy than investing in the US Bond Market is to invest in ETFs (Exchange Trade Funds) or mutual funds that buy baskets of bonds, and are constantly rotating their inventory. If interest rates go up they’ll take a hit on a portion of their portfolio, but they’ll then replace those bonds with others that pay more. You can choose ETFs by quality, from super safe Treasuries to middle grade corporate “junk” bonds, with less quality paying higher rates. And you choose by the average duration of the portfolio—short, intermediate or long term—with risk (and so volatility and potential rewards) increasing as the terms get longer.
The most extreme bet by duration may be PIMCO’s ZROZ, an ETF that tracks the BofA Merrill Lynch Long US Treasury Principal STRIPS Index. A STRIP is a financial instrument in which the holder receives no interim interest payments, just the par value at maturity; interim values are determined by the open market. And the ZROZ is a bet on what that instrument will be worth 25 years in the future, discounting for all the interest rate fluctuations between now and then.
As of May 2, 2014, ZROZ was up 18.19% YTD, compared to 2.56% for the S&P 500. On the other hand, ZROZ on the same date was down 13.52% over the preceding 52 weeks. This is not a “set and forget” market play, in other words. But if you’re an active trader or investor and want to participate in the bond market, then ZROZ and other fixed income ETFs may be worth a look.
Keep in mind that supply and demand among buyers and sellers, in addition to the underlying assets, figure in the fluctuating prices of these tickers. Why are bond funds in general beating the equity markets for the first part of 2014? It may be due to the fact that, even though interest rates have ticked up, the resulting effect (on business expansion and the overall economy) has not been as painful as some expected.