ETF Expert Corner

Sit Investment Associates’ Bryce Doty Previews Fed Meeting, Explains Sit Rising Rate ETF (RISE)

September 19th, 2017 by ETF Store Staff

Bryce Doty, Senior Vice President & Senior Portfolio Manager at Sit Investment Associates, explains why the Federal Reserve’s unwinding of their balance sheet could cause rates to rise more than anticipated, making a hedge such as the Sit Rising Rate ETF (RISE) a valuable component in a bond portfolio.



Transcript

You can listen to our interview with Bryce Doty by using the above media player or enjoy a full transcription of the interview below.

Nate Geraci: The first guest we have for you today is Bryce Doty, Senior Vice President and Senior Portfolio Manager at Sit Investment Associates. They manage the Sit Rising Rate ETF, ticker symbol RISE, and Bryce oversees some $7 billion in fixed income investments. Bryce is joining us via phone today from Minneapolis. Bryce, as always, great having you on the program.

Bryce Doty: Thank you, Nate. It's great being part of the program.

Nate Geraci: Bryce, let's start with the Fed. They conclude their scheduled policy meeting tomorrow and, of course, the expectation is that they won't raise interest rates. What are you expecting to hear and is there anything in particular you'll be watching for?

Bryce Doty: Yes. Tomorrow is all about the Fed's balance sheet. They're pausing on the rate increase because we're about to experience a precedent that has never been seen in the history of the world. This will be an attempt by a central bank to unwind a $4 trillion trade. As you know, the Fed printed money, created money out of thin air, started about five years ago, and used that money to buy bonds to drive down interest rates. Well, what they're expected to do tomorrow that is really going to grab all the headlines is explain how they're going to try and get themselves out of this, how they're going to try and unwind that trade, if you will.

Nate Geraci: Bryce, can you explain the potential impact of the Fed unwinding their balance sheet? How might this impact rates and how do you expect this process to play out?

Bryce Doty: Right. There's a lot of moving pieces. The easy answer is rates will go up. They bought the bonds to drive rates down, to drive bond prices up and the interest rates down. They had been raising short-term rates. They now feel that the economy is strong enough where they can start to sell bonds or let bonds mature. The impact is identical whether they sell bonds or let bonds mature. The cash disappears out of the banking system, and they're going ahead with it, regardless of whether there's a soft CPI print, if inflation looks weak or if employment looks a little weak. They've put themselves in a precarious position where they have to do something about the excess cash in the banking system, and the only mechanism the Fed has for trying to siphon out some of the excess cash in the banking system - there's over $2 trillion of excess reserves just sitting in various banks' reserve accounts and it's causing a problem that I don't think they fully anticipated - and the only way they can resolve this issue is to try and get cash out of the system. The only way they can get cash out of the system is to sell bonds or let their bonds on their balance sheet shrink. So, they're going to announce how are they going to do that. Now, when they bought the bonds, it was to get rates to go down. When they do the reverse, it's going to cause rates to go up.

Nate Geraci: Bryce, as I listen to you talk about this - the potential for rate hikes seems to get all of the headlines - but do you think the market is perhaps underestimating the impact that the unwinding of the balance sheet could have on the markets?

Bryce Doty: They could be, but it's difficult for them to really show what they think the impact will be, because the Fed is reinvesting all the money that they're getting from bonds maturing, so they are buying $40 billion a month, and as long as they continue to be a huge buying force, it's keeping a lid on interest rates. So, even if everyone knows or thinks or believes and understands that them not buying bonds anymore will cause rates to go up, the market can't reflect it as long as they're continuing to buy this massive amount of bonds month after month after month. So, it's not until they pull back will you really start to see yields rise.

Nate Geraci: As it relates to interest rates, right now, Fed fund futures show about a 55 percent probability of a rate hike in December. Is that your expectation as to when the Fed next raises rates?

Bryce Doty: It all depends on how this balance sheet reduction goes. If it looks like the market is starting to panic and yields spike, then they'll hold off, because yields will have gone up by themselves, they won't need to push rates up. If it seems like the market is absorbing this additional supply or lack of demand of buying from the Fed, then yes, they will raise rates. They've definitely changed their tone and their stance from normalizing short-term rates, which kind of meant one percent Fed funds, to now they're stating that they no longer need to provide stimulus. That means a neutral Fed funds rate, which is more in the two to four percent range, and we're currently at one and a quarter. So, they're telegraphing that they want to steadily move rates up from where we are right now.

Conor Kelly: Hey, Bryce, Conor Kelly here. There's been a lot of talk recently, obviously, about what happens to Yellen. Her first term comes up early next year and Trump has said that he's going to make a decision before the end of this year as to whether Yellen serves a second term or somebody else sits down in her chair. Can you handicap what you think is going to happen?

Bryce Doty: Yes, and I link it back to these reserves I was mentioning. The banking reserve has $2 trillion of extra cash sitting in there, and Yellen has decided to pay banks one and a quarter percent on that, to pay them the equivalent rate that they set the Fed funds rate at, and that is costing taxpayers, American people, $25 billion a year. This is a politically bad thing to do, to do a reverse Robin Hood, take from the people, the workers, and give it to big banks that are already quite profitable. So this, politically, is a bad policy. It's one of the reasons that they need to get this reserve rate cash down, because banks are so flush with cash, they're not fighting for new deposits. The average rate paid on savings is .06 percent. That's a national average, less than one-tenth of a percent. Yet, if banks hoard extra cash, they make 1.25 percent.

Conor Kelly: Right. Pretty good spread there.

Bryce Doty: So, I don't see Yellen surviving past January. I think there's going to be a new group of people coming in. You saw Fisher retire, the Vice Chair. There's three vacancies. There's a law that says that one of the people is supposed to have actual banking experience. They've been able to skirt that rule by having vacancies in the Fed governorships. I think the new feel or tone of the Fed will be a balance between academics and practitioners, and that's going to change the whole discussion. I think they'll be less interventionist. The balance sheet reduction may get accelerated. They want markets to behave naturally and freely like they always have. They know that it's ridiculous to have this massive incentive for banks to hold cash rather than lend it. I think that that will drive the change in the tone and flavor of the Fed in 2018.

Nate Geraci: Bryce, one other question here on the Fed, because I do want to look at the Sit Rising Rate ETF, clearly one of the biggest challenges they've had is achieving their desired inflation target, and we've talked on this program about the deflationary impact of technology. I'm curious, do you think that's a real issue for the Fed and, if so, how do they ever solve this problem, because it seems like the pace of innovation is accelerating. More robotics, more automation, artificial intelligence. Does that change how the Fed might approach monetary policy moving forward?

Bryce Doty: Yes. They don't have models to appropriately deal with that phenomenon. They said that they track it, but they don't know what to really do about it. One time when the then Fed Chairman Ben Bernanke gave a speech about that topic, talking about how iPads had declined in value, someone from the crowd yelled out and said, "Look, I can't eat my iPad." So, they have to have a balance. They have to be able to look at the technology impact, but they can't focus so much on that they forget about the fact that food and gas and all these other things have really moved up significantly in price, while all of those other things have fallen in price. So, it's a delicate balancing act for them, and I don't know that they have an answer to it, frankly.

Nate Geraci: Our guest is Bryce Doty, Senior Vice President and Senior Portfolio Manager at Sit Investment Associates. Bryce, let's now talk about the Sit Rising Rate ETF. Again, ticker symbol RISE, great ticker. This is managed by Sit Investment Associates and this ETF allows investors to profit in the event of rising interest rates. First, walk us through how this ETF is constructed.

Bryce Doty: Yes. It's designed so that if interest rates move up a full one percentage point, the share price should appreciate close to about 10 percent, so you actually make money instead of losing money when interest rates rise. It makes it a perfect hedge for most bond portfolios. The way it's constructed, it's patterned after something we've been doing for large institutional clients for a number of years. What we're doing is, we're going into the Treasury futures market, primarily for two-year maturities and five-year maturity Treasuries, because those are the ones that are really going to be impacted the most by this change in Fed policy. 92 percent of the bonds that the Fed has been buying on its balance sheet are between two and ten-year maturities, mostly concentrated in two to five years. So, we go into the futures market for those particular maturities, primarily, and we short the futures. When you short a futures contract, you have the opposite impact that everyone else has that's just buying things normally. So, if the price is going down as yields are going up, you're profiting because you're short. Essentially, shorting is almost like at the beginning of a summer, you borrow a shovel and you sell it to someone for 20 bucks because everyone wants shovels for summertime work and then, in the fall, when no one wants shovels anymore, you go buy an equivalent shovel for only 10 bucks and you give that shovel back to the person you borrowed it from and you pocket that extra 10 bucks. Maybe you had to pay the person a dollar rent over the summer to borrow their shovel, but you still end up making money as the price of the shovel fell from 20 bucks to 10 bucks. It's the same thing with bonds, you're essentially borrowing a bond hoping the Fed raises rates, drives down prices, and then you're able to buy the bond back cheaper and return it and pocket the profit. So, that's how shorting a futures contract works. It's complicated for most people, so we've wrapped it into this ETF structure where they don't really have to worry about everything going on behind the scenes, just buying a few shares allows them to instantly get all the benefits from the protection offered by shorting Treasury futures when rates are rising.

Nate Geraci: Bryce, you mentioned “protection”. I know that you like to equate buying an ETF like RISE with purchasing insurance on your home or your car. Obviously, you want to own the insurance before something bad happens. How much insurance do you think the average investor should have in their bond portfolio?

Bryce Doty: That's a great question. It is always key to have that insurance before the accident, right? On our website, sitrisingrateetf.com, right on the home page is a calculator to help people understand how much they could need, but a rule of thumb is it only takes a small amount, maybe 10 to 20 percent of a bond portfolio allocation to RISE to cut the interest rate risk in half. So, it'll probably cut the duration of the total portfolio in half and allow you to sleep at night knowing you have a little protection, a little downside protection, because no one really knows what's going to happen when the Fed reduces the balance sheet. I mean, common sense tells us that, hey, when they bought all those bonds, it drove rates down. As they get rid of all those bonds, rates will go up, but what will the ripple effect be on stocks and other things? That's the more complicated problem. So, whenever there's situations like that, where it's difficult to really predict what's going to happen, I think all types of defenses, ideas are great. Going into cash is probably the most conservative, but that's also really costly. You give up all your income and whatnot. I'd prefer having our clients stay in their bond portfolio, but just add a little insurance to it by buying some of RISE.

Nate Geraci: Bryce, we have about a minute left here. You mentioned “costly”. Obviously, the cost of any insurance isn't free. I'm curious, what might those costs look like for investors in RISE, in particular, if they don't end up needing the insurance any time soon because rates don't go up?

Bryce Doty: Right. On that calculator I mentioned, it will show the reduction in yield, which will change, depending on how much RISE. The rule of thumb that I use is for a one percent decline in yield, you can cut your interest rate risk about in half. So, I think that's a very cost-effective trade-off. You give up a little bit of income in this uncertain environment. You don't give it all up, but you give a little bit up for a lot of protection, and so we like that type of trade-off going into tomorrow.

Nate Geraci: Bryce, we'll have to leave it there. As always, we appreciate you joining us on the program. Excellent insight into the Fed meeting tomorrow, the bond market, and certainly a potentially very useful ETF with RISE. Thank you.

Bryce Doty: Thank you.

Nate Geraci: That was Bryce Doty, Senior Vice President and Senior Portfolio Manager at Sit Investment Associates. Again, the ETF is the Sit Rising Rate ETF and you can learn more about this ETF by visiting the website that Bryce mentioned, risingrateetf.com.