Here’s How To Hedge For 2018

December 21, 2017

Here’s How To Hedge For 2018

  • Everything looks good with the FED raising rates, but a look under the hood says otherwise.
  • There is a possibility that we won’t see three interest rate hikes in 2018.
  • When things look so good that they can’t get any better, it’s time to leave the party.



Introduction

On Monday, we discussed what the main global risks are. Today I want to dig deeper into how to start thinking about portfolio positioning around these risks.

The FED has started with its tightening policy which creates two investing opportunities. One depends on if the FED manages to increase rates three times in 2018 as planned, inflation rises to 2%, and the economy keeps growing at current rates while unemployment remains low. In such a scenario, everything that has worked well in the last 8 years will work well in 2018.

The second scenario is one where the current tightening becomes too aggressive leading to a slowdown in tightening which would probably create significant repercussions in the financial environment. In the past, the tightening always became too aggressive at some point, so let’s first look at when the current tightening could hit that barrier.

It’s All About Money

First, let me show you the monetary base for the U.S.

Up to 2009, the monetary base had been growing at a pace that was enough to sustain economic growth. Since 2009, the monetary base has been growing at a pace that was needed to sustain the whole economy.

Figure 1: U.S. monetary base. Source: FRED.

It’s clear how the FED’s quantitative easing has created a big difference in the monetary environment. With the FED now lowering the supply of money and increasing interest rates, the question is whether the banks, the ones that got all this money from the FED, will be willing to increase their lending activities in order to further stimulate the economy. The problem is that with monetary tightening and higher interest rates, lending money becomes risker as higher borrowing costs lead to more delinquencies. Higher delinquency rates in combination with higher interest rates could quickly lead to less bank lending which would be detrimental for the economy and keep inflation low.

Figure 2: Delinquency rate for credit cards, industrial lending, and consumer credit. Source: FRED.

As the above figure shows, delinquency rates have been rising in combination with the tightening activities. Therefore, if the FED’s activity is already severely impacting the economy, how long will it be before the FED abandons its current tightening policy?

The growth in bank lending has already slowed down significantly and further tightening will lead to more slowing down. What’s priced in the stock market is economic growth of at least 2.5%. Such growth is possible to achieve, but given the credit environment, highly unlikely. One-off events like taxes or other adjustments might help, but those are just temporary and don’t really help for the long term.

Figure 3: Bank industrial lending activity has slowed down. Source: FRED.



Another indicator that shows how many believe the FED won’t be able to continue with its tightening for long is the spread between the 10-year Treasury and 2-year Treasury yield. Higher interest rates should push Treasury yields higher, but that isn’t happening because the probability of further easing is around the corner. Add a global shock and you will be seeing the FED reverting its strategy in 2018.

Figure 4: 10-year Treasury yield minus 2-year treasury yield. Source: FRED.

There Is A Painless Way To Play This

A year and a half ago I urged readers not to invest in Treasuries because the rising yield would lower bond values. I was mostly correct as the yield on the 10-year note almost doubled, but now I’m starting to change my stance as all of the indicators we’ve discussed above indicate a possibility that yields go lower in 2018.

If yields go down and there is lower than expected economic growth, lots of the already priced-in stock market benefits would disappear. Therefore, the stock market might see a correction while bonds might return to the high levels we saw in 2016 where the 10-year Treasury yield was at just 1.3%.

Figure 5: 10-year Treasury yield. Source: FRED.



An interesting way to play this is to use Treasury ETFs that are low cost and, given that it’s Treasuries, the liquidity is provided (NYSEARCA: IEF).

Figure 6: iShares 7-10 Year Treasury Bond ETF 5-year chart. Source: Bloomberg.

As you can see above, the high reached in 2016 was $113.8 which offers a significant upside in case we see lower interest rates. Nevertheless, there is also a real possibility that we see much higher interest rates. Therefore, please understand a Treasury hedging strategy as something that has to be constantly rebalanced in relation to the risk of the remainder of your portfolio.

From a value and risk perspective, the higher the yield is, the lower the risk is and the higher the value of Treasuries are, so keep that in mind when rebalancing and deciding how to structure your portfolio in 2018.

© 2017 Investiv