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Beware of Anchoring to Low Interest Rates

May 25, 2021

When required to make an estimation, people generally begin by envisioning some initial, default number–an “anchor”– they adjust up or down to reflect subsequent information and analysis. This is referred to as anchoring bias, an information processing bias.  Numerous studies demonstrate that, regardless of how the initial anchors are chosen, people tend to adjust their anchors insufficiently and produce end approximations that are, consequently, biased. We are generally better at estimating relative comparisons rather than absolute figures. For example, suppose you are asked whether the population of Canada is greater than or less than 30 million. Because of the way the question was phrased, you will obviously answer either above 30 million or below 30 million. If you were then asked to guess an absolute population value for Canada, your estimate would probably fall somewhere near 30 million. This is because you are likely subject to anchoring from your previous response.  By the way, the answer is 37.9 million as of the last census in 2019.

In the investment realm today, many investors are anchored to low interest rates.  It seems inconceivable to many that interest rates could rise to historical levels.  For example, the US 10-year treasury bond is currently yielding 1.6%, which has risen dramatically over the past month from below 1%.  However, historically the average rate of the 10 year is over 4%.  Investors are anchored to low interest rates in the current environment.  However, interest rates could be on the rise.  The Federal Reserve has begun to imply that the easy-money policies during the pandemic may be curtailed as the vaccine led recovery shows increasing inflation.

The Wall Street Journal notes that “Several Fed officials said this week that the central bank is closely watching economic developments and will be ready to adjust policy when necessary. Minutes from the central bank’s policy meeting in late April, released Wednesday, reported that some Fed officials want to begin discussing a plan for reducing the Fed’s massive bond-buying program at a future meeting.”  Right here in St. Louis, the local Fed President James Bullard told reporters after a speech Wednesday:   “If we got to the point where we were comfortable on the public health side that the pandemic was largely behind us, and was not going to resurge in some way that was surprising, then I think we could talk about adjusting monetary policy.  I don’t think we’re quite to that point yet, but it does seem like we’re getting close.”

Many investors are not psychologically ready for an increase in interest rates.  Here at Sunpointe, we are encouraging clients to keep bond duration short.  Please reach out by email or call us with any questions or comments.