High on Duration
Today was the FOMC rate decision meeting. These meetings happen regularly and this one was not exceptional. Since the Great Recession in 2009 we’ve lived in a very low interest rate environment. These low rates have some interesting implications and the FOMC has been trying to “normalize” rates for the last few years.
Rate normalization has some implications which begin with understanding Duration (which is a bit boring and dry, but very important, so stick with me.)
What is Duration? Most simplistically, it is how much a bond's price will change given a change in yield. When yields go down, bond prices go up. There are multiple other definitions for Duration, but they have essentially the same financial meaning; it’s a measure of a bond’s price sensitivity to yield.
Why is this important? Well, let’s take a quick look at the data. If we regress the price changes of TLT, a US Treasury Bond ETF versus changes in the 10y yield, we should get an approximation of TLT’s duration. The “normal” period that the FOMC is trying to revert to was before 2009, so let’s split up the data into pre-2009 and post-2009.
Pre-2009, TLT had a duration of -7.0, post-2009, -14.2. So for every 1% change in yield, TLT would move 7 price points before 2009, and 14 price points after; the Duration (sensitivity) has DOUBLED.
If you own a lot of bonds (The Fed owns $4 TRILLION, yes, with a T), that probably isn’t to your liking. But, as the FOMC raised short-term rates, you have been mostly lucky because longer term rates have remained stable and low resulting in a flattening yield curve.
Low rates also have another effect, equities are largely valued based on discounted cash flows. Future earnings are “discounted” to the present using the appropriate term interest rate. When rates are low, there is LESS discounting and the sum value of all those future cash flows is higher, making stock valuations higher. So as rates rise, you’d expect stock market valuations to moderate or go lower.
2018 gave us two real-life market examples of how these concepts link together. In February, the 10-year US Treasury bond yield rose sharply from 2.5% almost to 3% causing a massive spike in volatility and subsequent stock and bond market sell-off. The rapidity of the event was a testament to the sensitivity (Duration) built into the market.
Then, in mid-September to early October, the 10-year yield spiked through the 3% barrier up to 3.2%. This caused a panic sell-off in the equity markets which forced fund redemptions and caused even more selling, perhaps irrationally, into year end.
By December, the FOMC had realized just how sensitive the markets were to changes in interest rates and moderated their future rate hike expectations. Markets rebounded. As of this last meeting, it seems the FOMC has “normalized” as much as it can.
We live in a world with very high Duration. The stable markets (2010-2017) we were accustomed to are both expensive (due to low rates) and very sensitive to changes in interest rates. So, going forward, it makes sense to build in a larger margin of safety when selecting investments and constructing or re-balancing your portfolio.