At the beginning of this year – investing legend and bond guru – Bill Gross – told us that the US 10-Year Treasury was the “key to everything” for 2017.
From CNBC at the time:
Whether the 10-year Treasury yield crosses the 2.6 percent mark will be critical both to the bond market and to stock prices, the fund manager at Janus Capital wrote in his monthly report for clients.
Higher yields reduce a bond’s face value. If 2.6 percent is broken on the upside … a secular bear bond market has begun,” Gross said.
“Watch the 2.6 percent level. Much more important than Dow 20,000. Much more important than $60-a-barrel oil. Much more important than dollar/euro parity at 1.00. It is the key to interest rate levels and perhaps stock prices in 2017″
So far Gross’ nominated 2.6% level has not been broken (more on why shortly).
We agreed that much lower bond prices would have a material influence on what we see in 2017 – both stock prices and housing alike.
However, we also felt the market had a greater ‘threshold’ than 2.6%…
For us, the pressure point was more likely closer to 3.0 to 3.5%.
My logic was if risk-free government backed bonds were paying 3.5%… then the yield offered by higher-risk assets (such as stocks) was far less attractive. This would see fund rotation. With that – let’s see how the 10-year treasury note is trading today and Gross’ warning…
The 10-Year Treasury Today…
Regular readers will be very familiar with this weekly chart:
For those less familiar – we were expecting the chart (bond prices) to ‘catch a bid’ around the 61.8% zone of a distribution we flagged from June 2013 – which (coincidentally) represented a yield of 2.6% (perhaps why Gross targeted this level)
Lately we have seen yields fall from their highs — and bond prices bid a little higher (as they bounced off the 61.8% zone of our structure).
And whilst this is great news for speculators (ie those with a mortgage) — it also tells us that the market is not entirely convinced of continued (strong) economic growth (eg ~2.5% and above).
In other words, they are still choosing to largely remain in the ‘safety’ of bonds… despite the yields being not much above zero percent in real terms.
If you are a new reader to the blog (welcome) — however I recommend taking a read of this post.
I explained how Treasury Inflation Protected Securities (TIPS) function and why they are great insight into the market’s expectations for real economic growth (and decisions on things like interest rates from entities such as the Federal Reserve):
We showed how real yields on the 5-Year TIPS have generally tracked the economy’s trend growth rate for the past two decades.
Again, this is important if we are trying to get a gauge on where things might be headed (ie and sentiment towards risk).
As an aside — there are skeptics who will argue that both TIPS and Treasury prices have been distorted by massive QE-related Fed purchases. I disagree and here’s why…
For example, as it stands today the Fed owns just under 17.6% of outstanding marketable Treasury debt (currently ~$14T) — and that is about the same share as they held in the pre-2007 period. Here’s the breakdown of all government debt:
- Foreign – $6.281 trillion
- Federal Reserve – $2.463 trillion
- Mutual funds – $1.379 trillion
- State and local government, including their pension funds – $874 billion
- Private pension funds – $544 billion
- Banks – $570 billion
- Insurance companies – $304 billion
- U.S. savings bonds – $169 billion
- Other (individuals, government-sponsored enterprises, brokers and dealers, bank personal trusts and estates, corporate and non-corporate businesses, and other investors) – $1.349 trillion.
But here’s the telling data point: treasury yields today are less than half what they were during that period.
The Fed currently holds about 9% of outstanding marketable TIPS, so Fed purchases of TIPS have had even less impact on the TIPS market than on the Treasury market.
In other words, the Fed’s purchases of these instruments are not distorting the real yields on TIPS today (despite what the perma-bears will argue)
Real Yields Key to Fed Decisions
I often go to lengths to describe the role of TIPS as the real yield on the funds rate plays a key role in the Fed’s deliberations on short-term rates.
For example, low nominal yields may sound like “free” money — however money is really easy only when real borrowing costs are negative.
And this has been the case post 2008 and the current expansion….
But as we highlighted during the week – real overnight yields are now rising, and beginning to be positive in real terms.
This is great news…
From mine, the current real yield on 5-year TIPS suggests that the market is expecting the Fed to continue to increase short-term real and nominal rates in coming years….
However, equally they are also not expecting the market to increased rates by that much…
Putting it All Together
If you are worried about interest rates – keep an eye on both (a) the US 10-Year Treasury; and (b) what we see with TIPS.
Whilst I believe the Fed will continue to raise the short-term rate in the near-term – the market doesn’t believe it will be by that much (eg no more than a further 50 basis points (ie 0.5%) this year).
Expectations for growth – as evidenced by what we see with TIPS – is moderate. And the Fed will be guided by what they see with real yields.
My take – expect slightly higher rates however nothing which gives us great cause for alarm.
Any hikes from the Fed will be slow and gradual… and the market is more than fine with that.
… trade the tape
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