Let The Economists Obsess Over Rising Rates

by Michael Batnick, The Irrelevant Investor

At this point you’re probably tired of all the speculation about whether the Fed will raise rates and when. I know I am, for the last eight quarters I’ve been receiving emails describing “how to play this rising rate environment.” I view this as a huge distraction and think this sort of debate is best left to the economists.

Interest rates are a key input to some of the most important valuation models so they are absolutely a critical part of the puzzle. However, so are GDP growth rates, unemployment and housing. Is it wise to make major investment decisions based on our GDP forecasts? James Osborne pointed out that what’s going on now is like this great Peter Lynch quote, but for bonds: “far more money has been lost preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” How many people have been overweight short-duration bonds for the last two plus years?

Interest rate risk is real, but what is just as real that we hear little about are the advantages to rising rates. This gives investors the ability to reinvest coupons at a higher rate. As you can see below, the ability to do just that did not destroy bond returns during the last five rate hikes.

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Another very important thing to keep in mind is that stocks will always have a higher probability for major drawdowns. Bonds just have not historically crashed the to the same degree that stocks have. The worst nominal three-year return for long-term government bonds was -18%, for stocks it was -82%.

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Now look at the chart again with the drawdowns from stocks included.

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All the hemming and hawing over how to protect yourself from rising rates seems silly when this is put into context. Does this mean that stocks are not exposed to interest rate risk or that inflation can’t eat into bond returns? Of course not, there are always risks to non risk-free assets. The point is that making major changes to your allocation based on what might or might not happen and the unknown affects that come along with it usually do not work in your favor.

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