Last week, the U.S. Federal Reserve announced the termination of its bond-purchasing program, also known as “quantitative easing”. This program, which was part of a broader plan to stimulate the U.S. economy, was designed to counteract the general economic weakness following the 2008 financial crisis. The end of QE leads us to new questions: Are we heading towards an increase in the U.S. short term interest rates? Similarly, are we heading towards an increase in the Bank of Canada short term interest rate? Is there an opportunity to time the bond market and generate some extra return?
Are we heading towards an increase in the U.S. Federal Reserve rate of interest?
While I can’t forecast (nobody can) interest rates reliably, I can provide a very accurate estimate of the market expectations. Indeed, there is a very active market to buy and sell short-term U.S. fixed income securities at future dates (known as “Eurodollar Futures”). This market tells us that short term rates are expected to rise by roughly 0.50% in the coming twelve months, a very modest increase.
Are we heading towards an increase in the Bank of Canada interest rate?
There is a futures market on Canadian short term fixed income securities as well (known as the Canadian Bankers Acceptance Futures). The market is currently expecting nearly zero change in interest rates in the coming year.
Is there an opportunity to time the bond market?
As mentioned before, I don’t believe the bond market is predictable, nor are timing strategies effective in generating excess returns. But we can ask: If we could perfectly forecast future Central Bank interest rate decisions, could we make money out of it? This question was answered in a recent presentation by Dave Plecha, who is the head of fixed income portfolio management at Dimensional Fund Advisors.
Plecha looked at the returns of short and long term Canadian bonds during the four significant episodes of rate increase by the Bank of Canada since 1980. The assumption is that since short term bonds are much less sensitive than long bonds to yield changes, the former should always outperform the latter during these episodes. Plecha’s analysis produced the following results:
Major Interest Rate Increases by the Bank of Canada 1980–2014
In the four significant episodes of Bank of Canada rate hike since 1980, short term bonds outperformed long term bonds only half of the times, which run against the intuition that short bonds should outperform every time. In reality, Central Banks’ rates are only one of many factors that influence bond behavior. As a result, even perfect forsight into future Bank of Canada rates would be insufficient to time the market between short and long term bonds.