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Rising Interest Rates: An Opportunity for Trend Followers?

 4 min read / 

US interest rates have been falling since the early 1980s. Most recently, in 2012 and 2016, the US 10-Year Yield fell below 1.50%. The only time that yields have been close to current levels was during World War 2 and afterwards through 1951 when the government enforced a ceiling.

Is this the early stages of 10-year yields, currently ~2.50%, moving back above 4% as they were before the Financial Crisis? Possibly.

A significant trend would likely mean there would be large trends in other markets as well. More trends the better.

Figure 1 — U.S 10-Year Note Yield (1962–2017)

The Fed appears committed to rising rates as long as the economy and inflation cooperate. Some people in the investing community have raised concerns that trend followers will not be able to perform as well when interest rates rise due to the negative carry when holding short positions in bond futures. They believe the main reason trend followers have performed so well since the early 1980s is because they rode the long side of the massive bond price trend. And if that gets taken away then trend followers lose their golden goose and will not perform well.

Their point on trading the short side of bonds might be true, but they seem to forget that trend followers diversify like lunatics and have the ability to profit from trends in other areas like commodities, stocks and currencies when rates rise. Trend followers do not rely solely on one market or asset class to provide all of the profits. If they do not make as much money from shorting bonds, fine; there are many other markets to profit from.

Major Trends During Rising Rate Environments

In the table below, it lists a small 12 market sample and their performance during each period. The cells in red are instances where trend followers lost money. All the way to the right, it lists the trend following performance for each period; performance includes data from an actual firm, the BTOP 50 index and a hypothetical backtest of a simple trend following system.

As can be seen, trend followers perform pretty well in rising rate environments, averaging a ~67% profit in the 16 occurrences since 1963.

In the early years (1963–1973), trend following portfolios were more concentrated in agricultural commodities. Then more markets, like metals and currencies, became available and allowed for better diversification. Today, portfolios include a wide variety of markets — commodities, currencies, stocks and bonds.

Due to their extreme diversification, trend followers are better equipped to capitalise on trends in a more efficient way if/when rates rise going forward.

Figure 2 — Individual Market Performance During Rising Rate Environments (1963–2017)

Past performance is not necessarily indicative of future results

A Longer Term Perspective

Dating back to the 1790s, there have been numerous periods when rates have increased, several scatted up-spikes through the 1930s and of course the massive trend from 1945–1981. This chart offers more perspective on how rates have moved over the past few hundred years.

Figure 3 — U.S 10-Year Note Yield (1790–2010)

Preparing for Anything

One can have no idea if rates will continue rising from their most recent low. The 10-year yield could go back 1.50% or lower for all anybody knows. The good news is that there is no need to know. It is enough that trend followers can watch and react, not try to be a hero by making predictions and big bets.

Currently, rates are rising and many trend followers are riding the uptrend. It remains to be seen where this trend goes.

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