Investment Challenges in Rising Rate Environments

1© 2018 Windham Capital Management, LLC. All rights reserved.
Confidential. Not for redistribution.
2018 1
Investment Challenges in
Rising Rate Environments
And the Role of Interest-Rate
Momentum
Andrew B. Weisman
Windham Capital Management, LLC
Managing Partner & CIO of Liquid Alternative Strategies

AGENDA
Investors now face a novel challenge; the potential for both higher interest
rates and a higher degree of stock/bond correlation
What we will cover:
• Examination of historical stock/bond correlation
• Examination of current economic stressors
• Consideration of the role of Interest-Rate Momentum

STOCKS VS. BONDS
Ten-Year-Note Yield
Correlation
2-Year Rolling Window Correlations Between S&P 500
Returns and Movements in 10-Yr-Note Yields
(May 1953 – June 2014)

STOCKS VS. BONDS
• Stock and bond prices tend to be negatively correlated only in low
interest rate environments
• Historically, 75% of the time stocks and bonds have actually been
positively correlated
• In high-interest-rate environments stocks and bonds have virtually
always been positively correlated.
• In a high interest rate environment, hoping that a bond allocation will
reliably serve to stabilize an equity portfolio is wishful thinking at best;
historically it has NEVER worked out that way.

THOUGHTS ON THE CURRENT ECONOMIC ENVIRONMENT
• “Inflation is always and everywhere a monetary phenomenon.”
• Milton Friedman 1956
• Unwarranted increases in the money supply will result in too much
money chasing too few goods; Inflation
• Since 2008 we have experienced a dramatic increase in our
monetary base; so-called “high-powered money”

GROWTH OF THE FED’S BALANCE SHEET
Billions
Source: Federal Reserve Bank of New York

COMPLICATIONS WITH THE MONEY SUPPLY
• Several more expansive definitions of the money supply
• Depending on how optimistic economic actors are, varying
amounts of spending and borrowing can occur resulting in
different “multiplier” effects on more expansive monetary
aggregates.
• Hard to imagine that a $4tn fiat increase in high-powered
money will not contribute to an inflationary bias.

THE FISCAL SIDE OF THE EQUATION
• Large corporate tax cut representing approximately a $1.5tn
fiscal stimulus
• Significant direct increase in government spending focused on
defense and infrastructure estimated to represent another $2tn
in fiscal stimulus
• Occurring at a time when the US economy is approaching
frictional levels of unemployment
• Not a great leap of faith to anticipate some degree of
inflationary pressure

WHAT WE’RE SEEING: THE FACTS
• Accelerating inflation
• Tightening monetary policy
• Rising interest rates

ACCELERATING INFLATION
210.000
215.000
220.000
225.000
230.000
235.000
240.000
245.000
250.000
255.000
2009-12-01
2010-05-01
2010-10-01
2011-03-01
2011-08-01
2012-01-01
2012-06-01
2012-11-01
2013-04-01
2013-09-01
2014-02-01
2014-07-01
2014-12-01
2015-05-01
2015-10-01
2016-03-01
2016-08-01
2017-01-01
2017-06-01
2017-11-01
US CPI
Dec 2009 - Feb 2018
Source: Federal Reserve Bank of St. Louis

ACCELERATING INFLATION
• Today’s Data:
– Core CPI up 2.1% Year on Year
– Headline CPI up 2.4% Year on Year
• Now officially above the Fed’s 2% Target!

TIGHTENING MONETARY POLICY

RISING INTEREST RATES

AUTO-CORRELATED DECISION MAKING: HISTORY

AUTO-CORRELATED DECISION MAKING: NOW…

BOTTOM LINE
• Rational Basis for Anticipating Higher Interest Rates
• Interest-Rate Decision Making Process is Highly Auto-correlated
• Probably in the Early Stages of a Prolonged Increase in Interest
Rates
• Higher Degrees of Stock and Bond Correlation Likely to Occur

INTRODUCTION TO INTEREST-RATE MOMENTUM
• Interest-Rate Momentum has historically been a strong ally in
both declining and increasing interest-rate environments
• Seeks to capture auto-correlation in the movement of interest
rates
• Makes use of quantitative “filtering” techniques that result in long
investments in persistent rising-price environments and short
investments in persistent declining-price environments.

MOMENTUM: THE THEORETICAL PERSPECTIVE
• Behavioral explanations include:
• Conservatism:
investors fail to fully “price in” new information
• Representativeness & Extrapolation:
investors tend to misestimate the frequency of risky events when
data is limited and tend to infer patterns where they don’t actually
exist
• Over Confidence & Self-Attribution:
investors tend to attribute success to skill and failure to bad luck

MOMENTUM: THE THEORETICAL PERSPECTIVE
• Technical explanations include:
• Portfolio insurance strategies:
investors attempt to control risk by replicating an option-like payoff
by buying a security as it moves up in price and selling it as it
moves down
• Limits to Arbitrage:
information sets are heterogeneous and it takes time and
resources for information to diffuse through a market
• Central Banks:
certain key market participants, such as Central Banks, tend to
exhibit highly auto-correlated policy decision making

INTEREST RATE MOMENTUM PRO FORMA PERFORMANCE
US TEN-YEAR NOTES & EURO BUNDS (FUTURES)
80
100
120
140
160
180
200
220
01/01/2001
10/01/2001
07/01/2002
04/01/2003
01/01/2004
10/01/2004
07/01/2005
04/01/2006
01/01/2007
10/01/2007
07/01/2008
04/01/2009
01/01/2010
10/01/2010
07/01/2011
04/01/2012
01/01/2013
10/01/2013
07/01/2014
04/01/2015
01/01/2016
10/01/2016
07/01/2017
Interest Rate Momentum
Sources: Bloomberg and Windham Research
Pro-forma returns are derived from Windham's proprietary modeling of the risk premia and do not reflect actual trading and they may not reflect the
impact that material economic and other factors might have had on Windham’s decision-making if Windham were actually managing money.
Performance does not reflect any management fee, transaction fee or other expense associated with managing an investment account. They are also
derived from the performance of investment models created by Windham and applied to a hypothetical account.

PERFORMANCE TAKEAWAYS
Sources: Bloomberg and Windham Research
• Persistent return generation during the last rising-rate environment, i.e.
2005-2007
• Exceptional performance generated during the declining rate
environment that prevailed during 2008
• Less compelling performance when rates on hold

CONCLUSION
• Looking forward, there is an enhanced likelihood that investors will face
a combination of higher interest rates and an increase in stock/bond
correlation
• Simple so-called “balanced” stock and bond portfolios are likely to be
challenged by their over-reliance on the assumption of negative
stock/bond correlation
• Interest Rate momentum provides an important tool to help investors
stabilize their portfolios across a broader range of market conditions
and directly address this challenge

Upcoming Webinars:
Windham Software Overview
Thursday, April 12th at 2PM EST
Portfolio Construction & Evaluation
Guest Speaker: Jon Kazarian
Tuesday, May 15th at 1pm
https://www.windhamlabs.com/webinars/

Thank you!
Questions? Contact us at info@windhamlabs.com

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The information contained in this presentation (the “Presentation”) is prepared solely for informational purposes. The Presentation is neither an
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any specific purpose. Past performance is not indicative of future performance, which may vary. There can be no assurance that the strategies’
investment objectives will be achieved. All strategies in this Presentation place investor capital at risk. Future returns are not guaranteed and a
loss of principal may occur.
References to market or composite indices, benchmarks or other measures of relative market performance over a specified period of time are
provided for your information only. Reference to an index does not imply that the Windham portfolio will achieve returns, volatility or other
results similar to the index. The composition of a benchmark index may not reflect the manner in which a Windham portfolio is constructed in
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Investment Challenges in Rising Rate Environments

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