Optimising Liquidity When Interest Rates Are Rising: Three Key Steps
By J.P. Morgan Asset Management
A rising rate environment can be a challenge even for the most sophisticated fixed income investor. And even though treasurers know further rate hikes are on the cards, they may happen more swiftly than some imagine. In this unpredictable environment, an actively managed ultra-short-duration strategy could be the optimal liquidity solution for treasurers.
The potential impact on liquidity management of the current rising rate cycle demands the attention of fixed income investors. Although interest rates in the US have already started to rise from historic lows, more rises are on the cards. What is less certain however, is how quickly these hikes will be enacted. This is making it challenging for treasurers to know what to do with their liquidity.
The good news is that by studying past rising rate cycles and using dynamic scenario analysis of potential future rate moves, treasurers managing liquidity through this environment can gain valuable insight that can help to inform their next steps. As part of their strategic decision making process, therefore, treasurers may wish to start including a review of the three major rising interest rate cycles seen over the last few decades:
- PERIOD 1: January 1994 to February 1995
- PERIOD 2: October 1998 to May 2000
- PERIOD 3: June 2003 to June 2006
Some key changes happened throughout these times, with an inevitable impact on credit spreads (see Figure 1).
Fig 1 - Credit spreads over recent rising rate periods
Source: Bloomberg/Barclays, J.P. Morgan Asset Management.
During Period 1, for example, the Fed hiked the fed funds target rate seven times over 12 months, from 3% to 6%. The average increase per hike was over 40 bps. Throughout Period 2, the Fed funds target rate rose six times over 11 months, from a starting level of 4.75% to 6.50% with an average increase per hike of 30 bps. And during Period 3, the Fed raised the fed funds target rate at a more measured pace of 17 times over 24 months from a starting level of 1.00% to 5.25%, moving 25 bps each time.
In Periods 2 and 3, the markets were able to anticipate and price in the tightening of monetary policy. But the 1994 tightening caught markets off guard. Both the fed funds target rate and US Treasury (UST) yields began to move higher – more or less simultaneously.
One of the burning questions on treasurers’ lips today is which of the previous rising rate cycles will the current period most resemble? Although the Fed is well on the way to policy normalisation, it’s still too soon to say. Nevertheless, historical data from the three periods above can help to pinpoint strategies that tend to outperform in periods of rising rates.
Armed with this information, treasurers may want to consider the following steps to help them prepare for rising rate cycles now and in the future.
Step 1: Analyse past performance to reveal the trends
By looking into the past, treasurers can identify trends that are likely to occur again if rates rise – regardless of the environment being different, or the pace of the rate hikes. For example, when rates are rising, previously issued fixed coupon securities typically decrease in value as investors shift to new, higher-yielding bonds. But because bonds with shorter maturities, floating interest rates and/or higher yields should experience less dramatic price declines in a rising rate environment, treasurers can potentially improve the total return of their bond portfolios by shifting to shorter duration and higher-income-generating strategies.
Here’s how the past performance analysis supports this conclusion.
Shorter duration strategies outperformed
Historical data from the three rising rate cycles above shows that strategies with shorter durations generally outperformed those with longer durations. For example, the BofA Merrill Lynch (BAML) three-month US T-Bill index (duration of circa 0.2 years), outperformed indexes reflective of core bond strategies, such as the Barclays US Aggregate (US Agg) and BAML US Corporate & Government (C&G) Master indexes (durations of approximately five years).
Higher-yielding strategies outperformed
Higher-yielding indexes fared better than lower-yielding indexes with comparable maturities. The BAML one- to three-year US Corporate-only index, for example, outperformed the lower-yielding BAML one- to three-year US C&G index (about 80% in government-related securities) for each period.
Pace and length of rate increases affect performance
When interest rates increase sharply and quickly, longer duration indexes underperformed more dramatically, failing to offset steeper interest-rate-driven declines in market price. When rates rose steadily over a longer period, as in Period 3, negative price returns were offset by greater interest income earned over a longer period, reducing the magnitude of underperformance.
Performance volatility is lower for shorter strategies
Strategies may exhibit similar overall returns during certain rising rate periods but their volatility can vary greatly. In Period 3, the US Agg and BAML one- to three-year US C&G indexes both generated positive total returns of similar magnitude, yet the BAML one- to three-year index had roughly one-third the volatility of the longer duration US Agg. Meanwhile, the BAML three-month US T-Bill index delivered higher returns and lower volatility than all of the other indexes shown, in all three periods.