An aggressive tightening cycle is most definitely upon us in many parts of the world. Before we delve into possible ways to respond, let’s briefly recap what has led us here:
Figure 1: How did we get here?
With that runaway inflation underway, it has been widely agreed that the Fed has been slow to react but amongst market participants, there is an expectation of decisive action in the form of numerous (and chunky) rate rises. It is important to note that central bank activity tends to have more influence on demand driven inflation (US) versus supply-led shocks (EU) so that could complicate things further.
Where does the widely watched US 10Y Treasury yield need to go for us to have a chance at staving off the demand-led inflation in the US?
Figure 2: Where does the US10Y nominal yield need to go?
Source: Aspect Capital, Bloomberg
- The problem is that real yields are still negative which means that credit is still relatively cheap
- If all else is the same, negative real yields mean that the real value of loans shrinks over time
- Mortgage and loan growth is very much inflationary
- US 10Y nominal yields need to exceed US 10Y inflation expectations to bring down inflation
- They have averaged ~3% over the past 20 years
- US 10Y inflation expectations have averaged around the Fed’s 2% target but have been above this for the past year
- Let’s assume that to have reliably positive real yields, US 10Y nominal yields might need to head north of 4%
- Central banks will need to influence this by increasing short-term rates
Source: Bloomberg
Rising rates can affect some asset classes positively and some negatively, hence traditional long-only investments may struggle to navigate the ensuing dynamics. So, the real question is: what could rising rates mean for various asset classes and which liquid alternative investment strategies could navigate these impacts?
| Fixed Income | Stock Indices |
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Long-term bonds have some of the highest sensitivity to interest rates (duration) so long duration could feasibly be the biggest casualty in a period of rising rates.
During the ascension period as rates rise towards their peak, investors tend to sell out of existing bonds, causing long-term yields to rise. Once rates hit their peak, capital may well flow back into these bonds causing price rises.
The very strong downward price trends can be captured by adaptive medium-term trend following. It is wise to diversify this across as many yield curves as possible so strategies that can trade interest rate swaps as well as bonds or bond futures can participate in emerging markets as well as developed.
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The US 10Y Nominal Yield is often used as the risk-free-rate (RFR) for pricing global stocks. As that goes up, we have to discount future equity cash flows which mean that stocks tend to re-price downwards. This particularly affects growth stocks versus value stocks on account of their longer duration. Broadly speaking, stock market corrections can be expected. If stock index earnings yields increase as they are sum of RFRs and the equity risk premium, their reciprocal PE ratios should fall, and if forward earnings estimates don’t change, current prices must fall. Late sharp rate rises can increase the risk of earnings cutbacks, recessions, and equity bear markets. These strong downward price trends can be harvested with trend-following. This could lead to increased volatility and fast self-funded options strategies can capture volatility expansions and nonlinear payoffs. Rotations between value and growth could boost relative value equity multi-factor strategies. |
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Potential Aspect Solutions:
Aspect Diversified, Aspect Alternative Markets, Aspect Core Diversified
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Potential Aspect Solutions: Aspect Core Diversified, Aspect Absolute Return, Aspect Defensive Options |
| Currencies | Commodities |
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Central banks that are first to hike rates often see currency appreciations, especially if markets believe that they know what they are doing. US-centricity means that the USD gains momentum vs other currencies as foreign capital flows into US denominated securities.
This is exactly where a risk-controlled FX carry model can exploit the myriad of interest rate differentials that will reverberate based on central bank timing.
The level of success in mitigating inflation will affect forecast and actual macroeconomic fundamentals that manifest in currency movements. Signals from relative value duration-neutral macro strategies would be expected to have some explanatory power here.
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Both demand shock and supply shock led inflation create the most notable upwards price action in real tangible assets such as commodities. Commodity heavy CTAs are able to benefit from these dramatic moves. Rises cannot continue indefinitely as demand destruction can ensue if prices soar too high. Monetary tightening can often lead to consumers pulling back on spending and travel so reversals should be expected. Higher interest rates increase the cost of carry and if markets are broadly efficient, futures prices exceed spot. This shift from backwardation to contango can be exploited in relative commodity carry models or futures term curve models. Strategies focused on commodity heavy regions and markets may be able to participate to a greater extent. |
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Potential Aspect Solutions:
Aspect Systematic Global Macro, Aspect Absolute Return
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Potential Aspect Solutions: Aspect China Diversified, Aspect Alternative Markets, Aspect Diversified, Aspect Core Diversified |
Only time will tell whether economies can mitigate the gloomy macroeconomic outlook.
Therefore, diversification across strategies which can benefit from the various themes that may emanate from this rising rate environment is worth serious consideration.
Disclaimer
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