Not another rates article… At the moment the market expects the Repo Rate to rise by at least another 2% over the next two years. Stating that, in such a manner, grants a degree of certainty and credibility to a subject that is, in actual fact, greatly different. Market expectations, especially regarding interest rates, are quite fickle and varied – yet discussions tend to ignore these underlying realities. To a large extent this is necessary because, as much as they would like to believe otherwise, the person on the street is a layperson when it comes to certain types of specialized knowledge. Engineering, law and medicine are all great examples of this. In discussions with their clients, they simplify the problem – and the clients accept their understanding. Few people argue a diagnosis with their doctors!
Investments are another example of specialist knowledge – especially interest rate forecasting.
In the opening sentence of this article, the current market consensus regarding the future of interest rates was stated. Yet, the tone seems to imply that several senior people, from various institutions, sat down, had a lengthy discussion and then reached some form of agreement. The reality is VERY different though. When we try to analyse market expectations, we look at something called forward rate agreements (FRAs). These are contracts between two institutions, fixing the rate at some time in the future. Think of this in terms of fixing the next two years on your mortgage rate. If a bank offers you 5% you would jump at it, whilst you would most likely avoid anything above 10%.
By looking at the rate that these two institutions can agree on, we can get an idea of how professional investors view the future. If the asking rate is too low or too high, either of the two institutions will feel disadvantaged and the deal will fall through. Right now, there are thousands of funds and institutions looking to fix a borrowing rate or lend at a fixed rate – and there are thousands of these types of deals occurring every day. Where supply meets demand is where the rate is set. Thus the FRA rate in two years time is not really a consensus at all, but rather an average – and averages, as we know, can massively distort the underlying complexities of a situation.
For example: At Atlantic we believe that the repo rate may only be 1% higher in 2 years, while other investors believe rates may skyrocket by well over 3%. Chart 1 shows the reality. The blue line is the history of the repo rate (and current consensus), while the grey lines denote the various opinions held by market participants.
This is one area where fixed income managers can earn their keep. If you believe that rates will rise less than expected, you can enter into a contract at the current market rates and, if rates then increase slowly, you generate excess returns. If you hold the converse opinion, you invest in instruments where the return rises with the interest rate and outperform that way. But the question may be asked, “Who are we at Atlantic Asset Management to question the wisdom of the mighty market?”
The point is, that historically market “consensus” has often been wrong. The reason is not because professional investors are stupid or incompetent, it is because economic circumstances change and views are adjusted accordingly. Most investors agreed that the Rand was too strong at the end of 2012, yet very few would have expected it to weaken from R8.50/USD to over R11/USD in little over 12 months (a 32% move). When events like this occur, our expectations and interest rate views have to adjust.
It is important to note that these reactions could still be based not just on changes to economic data, but also on fear and uncertainty – and it is in such cases that profits are to be made. Chart 2 shows the repo rate back to 2002, along with the 2-year market consensus at the end of every month. As you can see, the market gets it right as often as it gets it wrong. It under/overshoots the severity of the change; it gets the direction wrong and it misses the peak. In hindsight, 2009 to 2011, was a great time to fix rates, as market consensus was constantly calling the bottom – yet the reality was very different. And that is my final message: It is not easy; fund managers get calls wrong, which with hindsight, seem obvious. So stick to a fund manager that has shown a willingness to be flexible, along with the ability to adapt to the changes in circumstances. Doing so over the long-term can add incremental alpha, along with bringing peace of mind.