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Wells Fargo on What to Do with Rising Interest Rates

Wells Fargo's chief economist, John E. Silvia, recently made a very bold statement in a presentation I attended on May 5 - interest rates will definitely rise. He stated it's only a question of by how much will they rise.

I recently caught up with Mr. Silvia to ask him what an investor should do in such an environment. Here's what he said, as well as my take on it.

Why interest rates will rise
Silvia predicted that rates will rise in response to the dollar continuing to decline against non-European countries such as Japan and China. He stated that five to ten year rates will increase by 0.30 to 0.50 percent by the end of the year due to both the economy showing continued improvement and continued inflation. When I asked him whether these events should already be priced into those market rates, he agreed that they should, noting he felt both the recovery and inflation would be higher than market expectations.

What to do in this rising rate environment
If Silvia is right, his midpoint increase of 0.40 percent would cause a five year duration bond to drop by about 2.0 percent (.40 percent increase x 5 year duration). With the five year Treasury yielding only 1.78 percent APY, this would translate to a sizable loss over the next several months.

I asked Silvia what an investor should do in this environment, and expected him to say stay very short on the yield curve. He surprised me by recommending investment grade corporate bonds in the five to ten year maturity range. Five year corporate AA rated bonds were yielding 2.58 percent APY, translating to a lower probability of a net loss.

My take - don't be so sure
Forecasting longer-term rates is no easy task. In fact, a study by Bianco Research shows that the top 60 economists interviewed by The Wall Street Journal have been directionally correct on long-term interest rates only 35 percent of the time - far less than a coin flip. Silvia admitted that he was one of those 60 economists interviewed. Also, since his May 5 presentation, the five year Treasury yield has fallen by 0.35 percent, even as the US approaches possible default.

The findings from the Bianco study were devastating to me. I had previously thought I was uniquely qualified to wrongly forecast interest rates, but it turns out that I'm up there with the 60 top economists.

Have your Cake and Eat it Too
Silvia is one of the sharpest and most articulate economists I've met in some time. And he may very well end up being right on his increase forecast. The threat of rising rates scares the heck out of me, but the anxiety about what might happen shouldn't be confused with believing I know with certainty what will happen. I recommend the Ally Bank 5-Year CD with a minimal 60 day early withdrawal penalty. Paying 2.39 percent APY, it yields more than a five year Treasury. If rates do rise, I'll only need to pay the early withdrawal penalty amounting to about 0.40 percent and move it to the higher rate vehicle. I always recommend staying within the FDIC insurance limits to eliminate default risk, if Congress acts responsibly, that is.

The Ally Bank solution yields a greater return than Silvia's corporate bond solution if he is right on rising interest rates. If rates stay stable, however, the yield is nearly identical. Investment grade corporate bonds do have default risk, as any GM bond holder can attest to. Even ultra-short bond funds like the Schwab Yield Plus bond funds can lose more than half of their value. Those investors who took too much default risk need only think back to 2008.

My Advice
Your bonds are your portfolio's shock absorber. The vast majority should be backed by the US Government or an agency of the US Government. Rates can't go a whole lot lower and they will go higher at some point, I just know I don't know when. My feeling of rising rates has been wrong for some time now and may be wrong for a bit longer. CDs with easy withdrawal penalties are often the solution, but the devil is in the details which requires actually reading the disclosure statement.

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