Asset Allocation vs. Interest Rates

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While oil is gushing to the moon today I re-read this great PowerPoint from Edward Qian at PanAgora – Multiple Alpha Sources and Risk Management. In the presentation they have a slide that shows asset class returns broken into Fed tightening and easing periods.

I thought it would be interesting to take the five asset classes mentioned in my paper and recreate the study with data going back further to 1973. Each month I recorded the year over year change in interest rates, and then the next month returns for the asset classes. For example, if interest rates declined from 5% to 4% then that would be considered a Fed easing bucket. While any number of interest rates could be used, I simply used T-Bills (and I know T-bills don’t equal fed funds but it should be close being at the short end). Below is the chart for all months from 1973-2007. In periods of fed easing, stocks, foreign stocks, bonds and REITs all performed better which makes intuitive sense because they are all capital assets and benefit from lower interest rates. Commodities on the other hand, turn in twice the returns when interest rates are going up, which makes sense due to their correlation with inflation and unexpected inflation. A simple model would be to alter portfolio weightings based on trend in interest rates. Capital assets (stocks, bonds, REITs) should have a higher percent allocation when interest rates are going down, and ditto for commodities when interest rates are going up. If I get around to it I’ll report some portfolio performance numbers for this strategy.

The red dots are Fed Tightening periods, and the blue dots are Fed Easing periods. Click on the chart to zoom in.