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STA Weekly Report – Where Are Interest Rates Going?

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INSIDE THIS EDITION:

Where are Interest Rates Going?
Weekly Technical Comment
Medicare Open Enrollment Begins October 15th
401k Plan Manager

 

The Federal Reserve increased the interest rate by 0.25% on September FOMC meeting. The market now widely expects another rate hike in the Fed’s December meeting, as the economy enjoys the backdrop of a tight labor market and firm inflation readings. In total, the Fed is likely to raise interest rates four times in 2018, the fastest pace since the current rate hiking cycle started in 2015. As a point of reference, the Fed only raised rates once in 2015, once in 2016, and three times in 2017.

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As a rule of thumb, bond prices have an inverse relationship with interest rates. So, investors shouldn’t be surprised to see a negative return for a typical bond portfolio this year. For example, the Bloomberg Barclays Aggregate Index, a broad U.S. investment grade bond index, has returned -1.69% as of October 1, 2018. But even such a modest loss feels strange to bond investors who perceive bonds as a safe asset in investment portfolios. As a result, investors expect a stream of consistently positive returns. On the other hand, bonds can be the largest allocation for a retiree, who may feel uncomfortable with even a small loss in portfolio value.

Return numbers are the most obvious measures of investment performance and as a result are what bond investors naturally focus on. Even professional investors can have hindsight bias that affect their decision-making, in a negative way. Unfortunately, investment is all about looking ahead and deciding how best to position or reposition the portfolio according to future expectations of macroeconomic and fundamental drivers that ultimately determine future performance. For bond investors who are unhappy with their returns this year and are considering reallocating from bonds to other asset classes, it should be helpful to have an outlook on the future of interest rates so they can prepare their bond portfolio accordingly.

In January of 2018, we laid out our near-term outlook for interest rates. Doing so periodically allows us to dissect and understand the underlying drivers of interest rates so that we can change the portfolio duration as conditions evolve.

Source: STA Wealth Management

Most of the components of our January 2018 interest rate outlook, both short-term and long-term, have played out as we expected. As a result, interest rates have risen along the entirety of the yield curve. Short-duration bonds, especially floating rate bonds that have essentially zero duration, benefit most from such rate environment.

Source: U.S. Department of the Treasury

 

Where is the interest rate going from here?

For the short-term interest rate, our base case is that the current rate hiking cycle has largely run its course. According to the Fed’s own dot plot, there is one more expected rate hike this year, three hikes forecasted for 2019, and one final hike in 2020. Among those five future hikes, three have already been priced into the current yield curve. So even if short-term rates rise as suggested by the Fed, we expect less pressure on the prices of short-duration bonds. As a result, their decent yield and low volatility make the front end of yield curve very attractive now. Furthermore, the flatter yield curve greatly reduces the opportunity costs of forgoing slightly higher yield on longer-dated bonds. The key risks to our base case are higher than expected wage inflation resulting from a further tightening of the labor market or goods inflation should trade tensions further escalate.

 

Source: Bloomberg

Although we favor the front-end of yield curve, we are gradually becoming more constructive on the back-end of yield curve, with the yield on 10-year U.S. Treasury standing above 3%. Historically, the U.S. 10-year yield tends to run under nominal U.S. GDP growth with the exception of the hyperinflation periods investors experienced in the 1980s. After all, the long-term interest rate is function of growth and inflation.

Source: PIMCO and Bloomberg

Admittedly, we are in the late stages of the business cycle, a stage historically accompanied by higher inflation, which is a headwind for bonds. However, we may also experience a meaningful growth slowdown sometime in the next two years, as monetary policy becomes restrictive and the effects of fiscal stimulus gradually fade. This should provide a tailwind for bond and offset inflation pressure.

Source: Bloomberg

Accordingly, Bloomberg economists forecast the 10-year yield rising to 3.45% by the end of 2020, which is merely 0.38% higher than the current level. If this forecast turns out to be correct, the 2-year holding period return for the 10-year Treasury will be positive (about 2% annualized total return composed of negative price return and positive income returns).

Source: Bloomberg

Given the Federal Reserve’s plan to reduce its balance sheet and the European Central Bank’s plan to taper its own bond purchase program, long-term interest rates are likely to continue trending higher, in our view. So, we maintain our short-duration bias. However, looking ahead there may be a point when it’s wise to consider increasing duration exposure as the 10-year yield rises, not only as a good source of income but also as a hedge to equity market risk within a balanced portfolio.

 

  


Retail Sector Stumbles to Two-Month Low

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Retail stocks are having a bad chart day. The daily bars in Chart 1 show the S&P Retail SPDR (XRT) falling to the lowest level in two months, and trading below its 50-day average (blue line) by the widest margin since March. Earlier buying of retail stocks this year was hailed as a good sign for consumer spending and the economy. Recent retail selling doesn’t support that optimistic message. By itself, today’s selling might not be too concerning. The bigger concern is that continued retail selling may start to weigh down consumer cyclical stocks which are already starting to lose some upside momentum. Cyclical stocks are also in danger of losing their 2018 leadership role.

 

Consumer Cyclicals Are Losing Upside Momentum

The daily bars in Chart 2 show the Consumer Discretionary SPDR (XLY) dropping today, but not far from its September high; and still well above its 50-day average (blue line). But the XLY is losing upside momentum. Its 14-day RSI line (top box) dropped during September, and is dangerously close to falling below 50 for the first time in two months. Its daily MACD lines (overlaid over the price bars) have been in negative alignment for a month. Note also that the early September peak in the MACD lines was well below the peak reached during June. That “negative divergence” is another sign of a weakening uptrend.

 

Cyclical Sector May Also Be Losing Leadership Role

Consumer cyclicals have been the market’s strongest sector since the start of the year. But it’s now in danger of losing that leading role. The solid line in Chart 3 is a relative strength ratio of the Consumer Cyclicals SPDR (XLY) divided by the S&P 500. Notice that the ratio peaked in mid-June and has yet to exceed that summer peak. A second attempt at a new relative strength high during September appears to be failing. The ratio line itself has also fallen below its 50-day average (blue line) and may be headed toward a test of its August low. Loss of market leadership by such an economically-sensitive market sector could also carry a warning for the market as a whole.
 

Consumer Discretion Is Also Losing Ground Against Consumer Staples

One of the traditional ways to gauge short-term market sentiment is to compare the relative performance of economically-sensitive cyclical stocks to defensive consumer staples. That relationship, however, is also starting to weaken. Chart 4 plots a ratio of the Consumer Discretionary SPDR (XLY) divided by the Consumer Staples SPDR (XLP). After rising consistently over the last year, the ratio peaked in June and has been treading water since then. Two rally attempts over the last month appear to have failed. Today’s drop in the XLY/XLP ratio threatens to weaken its trend even further. Consumer cyclicals are today’s weakest sector. While defensive consumer staples (and utilities) are the two strongest sectors. That may be an early warning that investors are turning a bit more defensive.

Small Caps Are Also Dropping

Small cap stocks, which led the market higher during the first half the year, are also losing their leadership role. The daily bars in Chart 5 show the Russell 2000 Small Cap Index falling to the lowest level in two months, and well below its 50-day average (blue line). The red line, which is a relative strength ratio of the Russell 2000 divided by the S&P 500, has tumbled to the lowest level since March. That may have something to do with the reduction in trade tensions favoring larger multinational stocks. But it could also be an early warning that the stock uptrend is losing some momentum.

 

Weekly Snapshot of Global Asset Class Performance

If you have any questions, please feel free to email me at luke@stawealth.com.

Luke

STA Investment Committee

Luke Patterson, CEO & Chief Investment Officer
Mike Smith, President
Andrei Costas, Senior Investment Analyst (Equity Strategies)
Nan Lu, Senior Investment Analyst (Fixed Income Strategies)

 

 

 

What is the Medicare open enrollment period?

The Medicare open enrollment period is the time during which people with Medicare can make new choices and pick plans that work best for them. Each year, Medicare plans typically change what they cost and cover. In addition, your health-care needs may have changed over the past year. The open enrollment period is your opportunity to switch Medicare health and prescription drug plans to better suit your needs.

When does the open enrollment period start?

The Medicare open enrollment period begins on October 15 and runs through December 7. Any changes made during open enrollment are effective as of January 1, 2019.

During the open enrollment period, you can:

  • Join a Medicare Prescription Drug (Part D) Plan
  • Switch from one Part D plan to another Part D plan
  • Drop your Part D coverage altogether
  • Switch from Original Medicare to a Medicare Advantage Plan
  • Switch from a Medicare Advantage Plan to Original Medicare
  • Change from one Medicare Advantage Plan to a different Medicare Advantage Plan
  • Change from a Medicare Advantage Plan that offers prescription drug coverage to a Medicare Advantage Plan that doesn’t offer prescription drug coverage
  • Switch from a Medicare Advantage Plan that doesn’t offer prescription drug coverage to a Medicare Advantage Plan that does offer prescription drug coverage

Read Full Article Here

 

 




Disclaimer:

Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by STA Wealth Management, LLC), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from STA Wealth Management, LLC. Please remember to contact STA Wealth Management, LLC, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services. STA Wealth Management, LLC is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. A copy of the STA Wealth Management, LLC’s current written disclosure statement discussing our advisory services and fees continues to remain available upon request.

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