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Last week, BWM Financial continued to reduce interest rate risk in our tactical portfolios by reducing duration across the board. Duration is a measure of the sensitivity of the price of a bond to a change in interest rates. As rates move up or down, higher duration portfolios will move more in price than lower duration portfolios. Our portfolios are now 15-20% lower in duration than our benchmarks, driven by our belief that interest rates will rise at least moderately in the intermediate term.  

Given the protection offered by bonds during turbulent times, we do not think bonds should be abandoned as an asset class. That said, there are signs indicating the effectiveness of bonds might be more limited now than in the past. Multiple factors are behind this shift, including rising inflation expectations, reduced correlation benefits and expected interest rate increases by the Federal Reserve (Fed) over the next few years. Here we take a closer look at each of these factors and examine the thinking behind our recent portfolio changes.  

Inflation expectations breaking out to multiyear highs 

Inflation expectations are the rate at which people—such as consumers, businesses and investors—expect prices to rise in the future. They matter because actual inflation depends, in part, on what we expect it to be. 

Some market-based measures of inflation expectations have hit multiyear highs. For example, the 5-year inflation swap has risen to its highest level since July 2008, as shown in the upper portion of the chart below. Meanwhile, the 10-year swap has climbed to its highest point since March 2013 and the 5-year/5-year inflation swap is the highest since October 2017. It’s important to note that the bottom portion of the chart shows the 10-year swap is lower than the 5-year swap, which means the market is expecting some of the inflation rise to be temporary. 

While the rise in inflation expectations makes sense as the economy reopens and demand is exceeding supply, a sustained rise in these numbers should prompt bond yields to move higher as investors demand higher yields to compensate for higher longer-term inflation expectations. 

Correlation benefits waning 

Over the last 13 years, one of the big benefits of bonds has been the positive correlation between stock prices and bond yields. If bonds are dropping in value (prices going down and yields going up), stocks have historically appreciated in price. Perhaps more importantly, when stock prices have declined, so have bond yields, which has pushed bond prices higher. This historical relationship has provided excellent portfolio diversification benefits during turbulent market conditions. 

The bottom portion of the chart below shows the one-year rolling correlation of stock prices and bond yields. Notice how the correlation has been mostly positive over the last 20 years but has approached zero in the last year. This means the added diversification from owning bonds has declined to some of the lowest levels seen in the last 13 years. While this may be temporary, it is one of the reasons we have recently reduced our exposure to interest rates. 

Federal funds rate expected to increase 

After an unprecedented policy response to the COVID-19 pandemic, the Fed is likely to being tapering its asset purchases as soon as later this year.  

In our view, once the tapering of asset purchases is complete, the Fed will attempt to normalize interest rates by raising them slowly over the upcoming years. The chart below illustrates that the market is expressing a similar view. The chart shows market expectations for Fed rate hikes over the next three years. The black line in the top portion shows the Fed is expected to raise its overnight lending rate from 0% today to approximately 1.5%. With the 10-year Treasury note yielding approximately 1.6% as of this writing, we believe intermediate term rates will have to increase to compensate investors for holding bonds with maturities beyond an overnight timeframe, should the Fed actually follow the expected path of rate increases. 

Taking action in our portfolios 

At BWM Financial, we rely on a “weight of the evidence” approach to make tactical decisions in our portfolios. At the center of this philosophy is unbiased analysis and objective indicators from Ned Davis Research (NDR). Shown below is one such indicator, which combines both internal and external data to help determine if bonds are in a bullish or bearish zone. As the bottom portion of the chart illustrates, bonds have moved well into the bearish zone, where prices have historically struggled. 

The recent deterioration in bond fundamentals combined with the lack of correlation benefits, rising inflation expectations and potentially forthcoming Fed moves have prompted our decision to reduce duration and interest rate sensitivity in our tactical portfolios. We accomplished this by selling intermediate term bonds to purchase short term bonds of similar credit quality across all portfolios.  

As we stated earlier, we do not think bonds should be abandoned altogether as they may prove to provide an excellent place to hide during stock market turbulence. Rather, we are choosing to position our bond investments to be less sensitive to interest rate moves.  

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Investment advice offered through Stratos Wealth Partners, Ltd., a Registered Investment Advisor DBA BWM Financial.  The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Stratos Wealth Partners and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.