How to Buy and Sell Fixed Income Investments at the Right Time and for the Best Price 

Timing the Interest Rate Cycle

by Thomas Nogales Financial, LLC

Introduction

TNF has devised a timing model for forecasting the future direction of long term interest rates. It warns when the interest rate cycle is about to make a significant change. What’s more, it rarely trades and works well in up and down markets. It can’t predict how high or low rates will go or how fast it will happen. It is quite accurate though at detecting cyclical turning points in rates. The mechanism used by the TNF Interest Rate Model is quite simple and logical. Like our stock market model, it uses no convoluted logic or curve fitting.

Interest rates are the single most important factor in investment planning. That’s because all other investments are discounted relative to interest rate expectations. If an investor knew the future direction of long term interest rates, then assets could be bought and sold with a high probability of profit on each transaction.

Most of the subscribers to our Thomas Nogales Financial eletter are investment planners, financial professionals, or business people. For several years we’ve accurately timed the stock market with Thomas Nogales Stock Market Alert. With the addition of our Interest Rate Timing Model, TNF now provides a robust timing toolset that complements the skills and knowledge of our subscribers.

Our web site recommends a balanced portfolio approach to investing and we believe market timing can greatly enhance total returns within the asset classes.

Rising Rates and Asset Prices
Rising interest rates cause most financial asset prices to fall. That’s because new fixed income investments will pay a higher rate of return than the old ones. A shift into shorter term issues is wise. If rates are low and you know they’ll rise, then it’s an excellent time to consider selling real estate if disposition is desired. As rates rise existing home prices may fall since some buyers can’t afford the payments. At cyclical lows it’s best to lock in a fixed rate mortgage. In a stock portfolio you may want to shift money to stocks less sensitive to interest rate fluctuations. The dollar tends to strengthen as rates rise.

Falling Rates and Asset Prices
Falling long term interest rates cause asset prices to rise and business conditions to improve. At the peak of rates you want to buy long term fixed income investments. As rates fall these assets may appreciate dramatically. It’s an excellent time to begin shopping for investment real estate and flexible financing. It’s also a good time to buy a business because economic activity improves as rates fall. The purchase price of an apartment building or a business sells at a discount when rates are high and can later be refinanced at a lower interest rate. This is how fortunes are made. The dollar tends to weaken as US rates fall.

Interest Rates and the Average Investor
Now, compare the above interest rate strategies to the actions of amateur speculators. They buy homes when market activity is feverish amid low rates. They finance properties with adjustable rate mortgages and then rates rise. Inevitably, increased costs and diminished affordability cause the housing game to end badly for them.

Many household investors are quick to lock money into a five year CD soon after rates start turning up. Returns can be greatly enhanced by riding rates up with a money market fund and then locking in long at the peak. For example, in June 2006 money markets pay as much as the 10 year bond.

Retirees with cash payouts from a pension plan give their cash to an insurance company and purchase a lifetime annuity for retirement. Knowing the rate cycle is of tremendous importance when doing such a conversion.

The personal investor usually loses to Wall Street because they pay too much in fees for money management services or they purchase financial products at the wrong time. A knowledgeable and ethical investment advisor is of great assistance because they can bring opportunities to an investor’s attention. A good advisor and knowledge of the interest rate cycle creates a winning financial planning combination. The TNF Interest Rate Model makes this possible.

Since interest rates directly impact financial asset prices we can state:
Early knowledge of the cyclical direction of interest rates is the single most important piece of market knowledge an investor can possess.

Buying Bonds using the TNF Interest Rate Model
Bonds can be a very profitable investment if bought and sold at the right time. A period of rising rates isn’t disastrous for bonds if it happens gradually but it will result in muted total returns.

To show how profitable interest rate market timing can be, we’ll use a hypothetical bond fund as an example. Chart-1 below shows the yearly Total Return on the 10 year treasury bond with income from Interest and Capital Gains from 1970 to 2005.

Notice how Interest Rates (blue) rose until 1982 and then declined for the next 23 years. The gain or loss for each year is comprised of the interest earned and the capital gain (or loss). Rising interest rates can really hammer a bond fund. For example, in 1980 the Total Return (green) was dragged down by losses on Capital Gains (red) because rates went up.

For our hypothetical bond fund, we assumed a buyer bought the bond in January of each year and sold it at the end of December and then reinvested the proceeds the next month in January. Bond funds aren’t really managed this way but it serves to demonstrate how important capital gains and losses are to long term profits if we look at it on a yearly basis.

TNF Model vs. Buy & Hold
In Chart-2, we show how Buy & Hold performs relative to the TNF Interest Rate Model. Notice all the years when Buy & Hold (in Red) had losses. Our model (green) avoided most of the losing years when interest rates rose rapidly.

The years around 1980 were especially disastrous for bonds as rates rose to over 12% due to high inflation. Over 35 years the TNF model avoided all years with capital losses except for a tiny loss in 1997 and a 13% loss in 1999 when the Long Term Capital Management collapse caused rates to rise in a panic.

Interest Rate Cycles
Interest rate cycles as measured by our model average about 6 years but with a lot of variance – from two years to nine years during our test timeframe. Chart-3 below shows the six pairs of TNF buy and sell points over the last 35 years.

Our model bought a bit early twice during the 1980-83 inflationary rate blow-off but both trades were hugely successful. All of our model’s sell signals occurred at interest rate bottoms just before rates began to rise. We couldn’t detect the 1999 rate run-up caused by the Long Term Capital Management (LTCM) meltdown because this was a credit panic and not a monetary event.

Chart-3.

The TNF Interest Rate Model was out of bonds at all points between an S and a B. Over the 35 years, the model was in bonds 277 months and out 261 months. During the “out” months the model earned the prevailing money market interest rate. During periods of rising rates, money markets generally pay quite well.

A downward trend in rates dominated since 1981. On average, interest rates declined 276 basis points (2.76%) after a buy signal. Interest rates rose 173 basis points (1.73%) after a sell signal. The average move of combined buy and sell signals was 194 basis points (1.94%).

TNF Model Buy and Sell Dates

Avoiding periods of rising long term interest rates pays off enormously over time. Chart-4 shows how $10,000 would grow over 35 years if using Buy & Hold vs the TNF Interest Rate Model in our hypothetical 10 year bond example. This stunning difference in performance is merely the effect of cash compounding for 35 years at 11.6% yearly vs 7.6% for Buy & Hold. Plus, the TNF model was only in bonds 63% of the time thus providing a lower level of market risk. In fact, using the TNF Interest Rate Model, an investor could have bought bonds and done better than stocks over the same period!

Housing Prices and Interest Rates
Interest rates have a 1:1 correlation with bond prices but most other assets are different. Stock price cycles are not directly aligned with the interest rate cycle. Housing lags interest rates.

The extremes of interest rates impact housing more than the peak or trough point in rates. Forecasting the extremes of an interest rate cycle is very difficult because a nation’s fiscal management and monetary policies also come into play. (TNF is delighted with just being able to time the turning points.)

Let's look at housing. In the US, home prices have experienced five downturns since 1970.

Home Price Downtrends
January 1974 – November 1974
April 1979 – October 1982
January 1988 to December 1992
July 1994 – February 1995
October 2005 to 20??

You can look at Chart-3 and see how the declining months relate to interest rates. All, except for the lengthy 88-92 decline occurred as rates head back up from a bottom.

Summary
Knowing the direction of interest rates is of enormous value for personal investment and business planning.

The TNF Interest Rate Model accurately catches the tops and bottoms of major interest rate cycles. Changes to tangible asset prices lag after interest rate turning points and for a while continue on their old trajectory. This lag of asset prices relative to interest rates provides plenty of time for the astute investor to take action.

Our model indicated rates would rise as of January 2004. Since then, rates have risen from 4% to 5%. Housing prices usually peak well after the interest rate trough. Median home prices peaked in October of 2005 and have since declined.

At the time of this article (June 2006), we would advise buying only money markets or a CD of less than one year. Short term bond funds of 1-3 years should be avoided while the FED is raising interest rates. Investment advisors should wait until our model indicates rates have peaked before making major committments to interest rate sensitive assets like long term bonds and annuities.

The stock market is independent from the interest rate cycle and should be timed with our TNF Stock Market Alert product.

Best regards,

Thomas Nogales Financial, LLC

www.thomasnogales.com
Tom Gleason, Manager and Researcher