June 01, 2021
Successful fixed income investing requires ongoing tactical and strategic analysis. At Roosevelt Capital Management (“RCM”), tactical considerations revolve almost entirely around our perspective on the liquidity and solvency of the issuers of individual securities, two topics we have already partially covered in prior letters and will continue to discuss in the future. Our overall strategy and whether we should consider modifying it, on the other hand, is regularly being evaluated against our perspective on macro-economic factors, including inflation and interest rates. One way we evaluate these items in practice is by monitoring the market’s expectations of each.
In our last letter we discussed how investors can determine the market’s expectations for inflation by looking at breakeven rates. In this letter we continue our discussion by exploring how the market establishes expectations for future interest rates by looking at “forward rates;” forward rates are the market’s expectations of future interest rates.
What Is a Yield Curve?
To understand forward rates, one must first understand yield curves because forward rates are derived from their corresponding yield curve. A yield curve is simply a graphical representation of the interest rates on a specific type of debt for a range of maturities. While a yield curve can be created for any class of debt security, when investors talk about “the” yield curve, they are invariably, at least in the United States, referring to yields on US Treasuries. Below is the US Treasury yield curve as of 6/11/2021.
As shown by the graph, an investor that allocates capital to 2-year US Treasuries receives an annual yield of 0.16%, an investor that allocates capital to 10-year US Treasuries receives an annual yield of 1.47%, and an investor that allocates capital to 30-year US Treasuries receives an annual yield of 2.15%.
The shape of the yield curve today is upwardly sloping and is known as a “normal” yield curve. Why normal? Because it makes logical sense. The longer one invests their money the higher return on their capital he or she would expect to receive, and represents historically at least, the common case situation in the US economy. There are two other main shapes for the yield curve: inverted and flat. We will discuss these shapes and why they occur in a future letter, however, it is important to understand that each shape says something very different about the market’s future expectations for interest rates. Since the current yield curve is normally shaped, that will be our focus today.
The Market’s Expectation for the Yield Curve
As noted above, embedded within the yield curve is the market’s expectations for future interest rates. The formal methodology used to calculate the forward curve is known as “bootstrapping” and is beyond the scope of this letter. However, like other concepts we have covered already, there is a relatively simple back of the envelope calculation that is both intuitive and, in this interest rate environment, quite accurate.
As of 6/11/2021, the yields on the 1-year and 2-year Treasuries were 0.05% and 0.16%, respectively. In practical terms considering the cash flows involved, this means that if you bought the 1-year Treasury today, you could expect a nickel of income for every $100 invested, over 1 year. For the 2-year Treasury, you would expect 32 cents of income, receiving 16 cents each year. How can we use this information to calculate the market’s expectations of the 1-year rate in 1 year?
The answer is that I could sell or “short” the 1-year Treasury and buy the 2-year Treasury. This strategy obligates me to pay out a nickel on the 1-year Treasury but with the expectation that I receive 32 cents over the life of the 2-year bond, for a cumulative cash flow of 27 cents or 0.27%. Put another way, in one year, the market is betting that the 1-year Treasury will be trading at a yield of 0.27%, which is 0.22% higher than today’s 0.05%.
One can, as mentioned above, do this for any maturity and then construct a yield curve for that forward period. Shown below is what the market expects the yield curve to look like in 1 year as well as the current yield curve.
The key insight is that the bond market expects that interest rates are going to be higher across the entire curve in 1 year vs. today. How much higher? In 1 year, the market is betting, as mentioned above already, that the 1-year Treasury will be trading at a yield that is 0.22% higher than today, the 5-year Treasury 0.39% higher than today and the 20-year Treasury 0.12% higher than today.
What We Should Take from All of This?
First, at least according to the market, the probability that interest rates are going to rise is very high. Second, the market expects about 1 rate hike of 0.25% per year over the next the 5 years. And third, expect the mid and long end of the curve to increase less than the front end. How sure are we of these expectations? Nothing is guaranteed of course, and the real world will always turn out differently than expected. With that said, empirical evidence shows that forward rates are more accurate at predicting changes in the front end of the curve, so we expect the statement above to put us “in the ballpark.” We are constantly monitoring the market’s expectations and will adjust as the market changes, particularly regarding our short duration strategy.
What does this Imply for RCM Clients?
Interest rates are not expected to rise so quickly or so much that we should wait to invest. In fact, interest rates could rise significantly more than expected and we would be better off by allocating capital today rather than waiting for higher rates.
Forward rates provide a wonderful mechanism to cut through the noise separating the people that make a living talking about things like interest rates from the investors who actually allocate precious capital. While forward rates cannot predict the future, knowing that they signal a market expectation that the Fed is going to hike 25 bps per year over the next 5 years is a valuable tool that helps us make more thoughtful strategic decisions.
Please reach out to us with questions and comments. Thank you for trusting RCM with your capital. It is a privilege for us to serve you.
David and Mike
Disclaimer
Roosevelt Capital Management LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein.
Past performance is not indicative of future performance. Principal value and investment return will fluctuate. No guarantees or assurances that the target returns will be achieved, or objectives will be met are implied. Future returns may differ significantly from past returns due to many different factors. Investments involve risk and the possibility of loss of principal.
The performance and characteristics information contained herein is for accounts solely managed by David Roosevelt, Managing Member of Roosevelt Capital Management LLC. Investment performance and characteristics through September 2019 are for Roosevelt Investments accounts managed by David Roosevelt. Investment performance and characteristics for October 2019 and thereafter are for Roosevelt Capital Management accounts managed by David Roosevelt. The performance information has been certified by ACA Compliance through December 31, 2018 and is available upon request. The values and performance information contained herein do not reflect management fees. While all the values used in this report were obtained from sources believed to be reliable, all calculations that underly numbers shown in this report believed to be accurate, and all assumptions made in this report believed to be reasonable, Roosevelt Capital Management LLC neither represents nor warrants the reports, values, calculations or assumptions and encourages each prospective investor to conduct their own review of the reports, values, calculations and assumptions.