1.8% TSP G fund (formula determined and unique to TSP and Social Security)
1.9% TSP F fund (AGG ETF which also tracks the Barclays US Aggregate Bond Index)
The TSP G fund’s interest rate in May was 1.8% versus the F fund’s last 30-day SEC yield of 1.9%. The G fund’s interest rate and F fund’s yield remain fairly close overtime. The primary difference in performance comes down to the TSP F fund’s capital gains or capital losses which result from the movement of interest rates. If interest rates move down, the TSP F fund incurs capital gains but the TSP G fund does not.
For every 1% change in interest rates, the F fund will sustain a gain or loss 5% in price in the opposite direction – although not all at once. Since the long term trend in interest rates since the early 80’s has been down, the F fund has outperformed the G fund due to capital gains since its inception. Since 2003, the TSP G fund is up 50.4% versus the TSP F fund’s 77.9%. The downward movement of interest rates has not been steady and has seen its ups and downs.
If an investor had a crystal ball, they would move into the TSP F fund when interest rates are falling and avoid the TSP F fund when interest rates are rising. If interest rates held steady, both funds should perform fairly close on a monthly basis. But since the F fund comes with default risk, one should lean toward the TSP G fund.
For those investors who want to minimize management of their TSP accounts, I recommend allocating to the TSP G fund when not otherwise invested in equities. The risk is missing capital appreciation during times of falling interest rates. Today your opportunity costs if interest rates drop to their lowest historical level ever would be only the 3% capital gain of the F fund (this implies the TSP F fund yield would drop 0.6% to around 1.3%) This could happen in today’s deflationary environment and we may even see a new historical low in interest rates.
Predicting Interest Rate Movements
Predicting the direction of yields (thus price) of the TSP F fund is always challenging. Short term reversals can wipe out months of gains. The 5-year duration fund is sandwiched between downward trending long-term rates and the shorter duration interest rates that are controlled by the Federal Reserve. The Federal Reserve does not actually have to raise or lower interest rates to see movement in interest rates, they only have to provide “forward guidance” and rates may react. The market does not always act as the central bank’s expect especially in today’s environment.
The market is constantly acting on expectations of future Fed actions and other variables. One other important variable affecting the F fund are investor flows into fixed income assets driving yields down as prices move up. These flows often occur when money is leaving the equity funds whether slowly over time or during rapid market corrections. It is not just US investors that affect flows in and out of US bonds – foreign investors also shift allocations. Currently, the push for negative interest rates in Europe and Japan is causing money to flow into the better yielding US bonds.
Interest Rates Today
The longer duration bonds have been trending down since the early 80’s and show no sign of stopping even as we approach zero thanks to the ECB and BOJ push into negative rates. I do not believe US bonds will go negative, but they do have more room to fall. Using Treasuries as our proxy we see the 10-year constant maturity is only .2 above its lowest rate and the 5-year is .6 above its lowest historical interest rate.
The 5-year rates spread above their historical lows is due to expectations of future Fed hikes. This week, it appears the Fed began to capitulate on raising rates based off a weakening picture in the labor market coupled with the downward trend in industrial production. In the past when the Labor Market Conditions Index hit -5, the Fed began easing by lowering interest rates. We are at -5 now, but since the FOMC only raised rates once this cycle they don’t have much to give back.
Again, the Fed does not actually have to lower rates to see interest rates begin to fall. The weak economic data is already pushing expectations of the next rate hike well into the future and my guess is they will be looking for ways to ease soon. Without the upper ward pressure on the short end and the continuing pressure on the long end, our 5-year duration TSP F fund may see its yield continue to fall and the fund will capture some capital gains while rates fall.
The downward direction of long term rates has been driven *recently* by Japan and ECB driving interest rates into negative interest rates. The Central Banks have been manipulating interest rates lower through the purchase of bonds and now corporate bonds in the EU. The risk is they lose control of their experiment and rates explode higher. In 2015, bond king Bill Gross called the German Bund (bond) the short-of-the-century and German interest rates along with US rates surged 1% in a short period of time. The TSP F fund lost 3% on that move and erased the previous year’s capital gains.
My belief is that this push to negative rates by Central Bankers is not for the economic growth but the desire of the central banks to buy as much of the government debt as possible then convert the debt to zero coupon perpetual bonds. By converting and holding this debt indefinitely, they in effect monetize past debt and hope to remove the debt load from the governments, banks and some corporations – debt alchemy. The outcomes of such a policy are unknown, but policy makers may see no other way out of the current debt situation.
Another risk to policy and interest rates is that inflation begins to take hold and puts pressure on the Fed to respond with higher rates even as the economy weakens and the financial markets swoon. This is not something the market expects because a weakening economy usually does not result in higher inflation. But much of the CPI is made up of basically the cost of renting houses (not home prices). Rents are starting to climb and this is pushing the CPI higher.
The Fed has already said they will let inflation run a little hot if necessary, so this type of inflation is not a large threat. The threat of inflation comes from monetary policy and how the market reacts to it. For the most part, monetary policy has been transmitted to the financial markets and not the economy. Ironically, it is wage inflation that would cause the CPI to overheat and cause the Fed to raise rates and put the brakes on the economy after years of stagnate wage growth.
I continue to recommend the TSP G fund as their primary low risk fund. For non-TSP accounts either short duration Treasury funds or in today’s low interest world the safety of an FDIC insured sweep money market account. Moves into the TSP F fund or AGG ETF should be use to capture expected downward moves in interest rates with predetermined exit points. Then back to your safe haven fund.