- Is the 10-year yield set to challenge 4.0% again?
- Why short-term yields offer a real alternative to equities
- A trade idea on the back of bond yields rising
Without exception, the most important financial asset on the planet is the US 10-year treasury.
Why?
Your mortgage, car loan, student debt, credit card all center on this asset.
Consider 30-year fixed loans in the US…
Mortgage demand fell 7.7% last week as borrowing rates surged to 6.39% on the back of higher 10-year yields.
Econ 101: make something more expensive and expect less of it.
It doesn’t matter what it is.
As an aside, at the start of every day, one of the first things I look at are bond yields.
This alone can set the scene for what’s ahead.
Let’s take a look.
Background
A large part of the reason I do this blog is to help people with financial literacy.
And fewer things are as important as bond yields.
Yes they are boring… sure… but these ‘boring instruments’ impact every financial asset (and that includes money!)
Today we will dive into why treasuries (or government issued debt) are critical for you to understand.
Even if you only trade equities – you need to understand how bond yields will impact your investments (stocks, property and cash)
What’s more, they are excellent investing vehicles which can generate powerful returns (more on that shortly)
Every investor should have a range of “tools” at their disposal… this is an important one.
First some background for those less familiar…
A 10-year Treasury is a bond that guarantees interest plus repayment of the borrowed money in a decade.
In fact, the “10-year” (as it’s known) is one of a handful of securities issued by the U.S. government. Others include:
- Treasury bills, also known as T-bills, are short-term securities, with maturities that range from a few days to 52 weeks. Treasury bills are sold at a discount to their face value, meaning they provide investors with returns by paying them back at the full, not discounted, rate.
- Treasury notes, also known as T-notes, are issued with maturities of two, three, five, seven and 10 years. They pay interest every six months and return their face value at maturity; and
- Treasury bonds, also known as T-bonds, are the longest-term government securities, issued for 20 and 30 years. They pay interest every six months and return their face value at maturity.
The 10-year treasury yield is the current rate these notes pay investors if they bought them today.
At the time of writing – that rate is 3.79%
You can obtain a quote here from Bloomy; and similarly, you can chart the yield here from the Fed Reserve’s site.
Below is trend in these yields over the past 40+ years:
Feb 15 2023 – US 10-Yr Treasury Yields 3.79%
Why This Matters
Changes in the 10-year tell us a great deal about the economic landscape and global market sentiment.
For example, declines in the 10-year yield generally indicate caution about global economic conditions.
However, if we see this yield gain (like we do at present) – it signals global economic confidence.
Here’s another way to frame it:
When investors are fearful of the outlook, they look to buy US Treasuries which in turn drives their yields lower.
On the other hand, when investors take on more risk and feel confident in the economy (e.g. buying stocks) – they will look to sell treasuries which pushes yields higher.
Consider two points on the 40-year chart above…
- July 5, 2016, the 10-year Treasury yield had fallen to a (then) record low of 1.37% shortly after the conclusion of a referendum in which the citizens of the United Kingdom voted to leave the European Union (“Brexit”). This political earthquake rattled markets around the world – which saw investors buying US bonds for safety – causing these yields to decline.
- On the other hand, when Donald Trump was elected president in November 2016, the 10-year yield gained considerably, rallying from 1.40% to reach 2.60% by mid December as investors felt more confident on the outlook for the economy.
Two things to summarise:
- The US 10-year yield impacts the rate at which companies and governments can borrow money. When the 10-year yield is high (like it is today) – governments, companies and individuals all face higher borrowing costs; and
- There’s arguably no safer investment at this scale. When ‘trillions’ of dollars are seeking safety – this is the only place they can hide. Coupon payments provide guaranteed income, and your investment will be safe regardless of what happens in the economy or the financial markets
Let’s now take a look at what we see in the bond market today… as things are shifting once again… and that spells opportunity.
10-Year Yields are Rallying
At the time of writing, the US 10-year yield is trading just below 3.80%.
Below is the long-term chart:
Feb 15 2023
The recent rally is not hard to explain…
In short, investors are feeling more confident about the economic outlook (a potential soft landing).
This results in a move out of bonds and into equities – pushing yields higher.
But the difficult question is – how high will these yields go?
Obviously no-one can answer that with precision (if only!)
However, I can at least offer my thesis.
My best guess is the US 10-year is likely to retest the range of 4.00% to 4.40% over the coming weeks and months (purple shaded ellipse).
Now not long ago the 10-year peaked around 4.40% and pulled back sharply – falling to 3.33%
However, after perceived strong economic data (e.g. strong jobs and retail data) – yields resumed their upward trend.
Now if see the US 10-year trading above 4.0% – they provide a viable alternative to much riskier equities (especially with the S&P 500 trading at near 4100)
Think of it like this:
With the S&P 500 trading 18.0x forward earnings (assuming earnings hold at $230 per share) – it’s questionable how much upside remains.
For example, if we stretch that multiple to 19x (which is considered extremely high with rates above 4.0%) – that puts the S&P 500 at 4370.
That’s a lot of risk for a just ‘5.3%’ upside – versus a risk free return of 5.0% with 6-month treasuries.
Right?
But let’s scroll back…
When Powell addressed the market on Feb 1 – the 2-year was trading at just 4.10%
At the time I called out the massive differential to the Fed funds rate – some 50+ basis points
Today that gap has closed – with the 2-year yield now 50 basis points higher.
Bonds are now aligned with the Fed.
Put another way, bonds are no longer expecting rate cuts in 2023 and are now looking for more rate hikes.
Equities on the other hand still haven’t received the memo…
Which brings me to our potential trade…
A Potential Trade w/TLT
Before I describe the trade – below is my thesis for yields over the next 12 months:
- First, I’m expecting 10-year yields to push into the zone of 4.00% to 4.40%.
- Second, I also expect these yields to remain in that zone for a 3-6 months (mostly on investor optimism the economy will land ‘softly’); and
- Third, as the economy weakens in the second half of the year – and the prospects of a recession increase – investors will seek the safety of treasuries.
If this script is correct (and it may not be) – equities will represent higher risk and rotate back into bonds – sending yields lower.
So how do we trade this?
Here I’m looking at the ETF TLT.
Now if you recall, I recommended a trade on this in October when it was trading down levels of around 95.
At the time, 10-year yields were pushing 4.40% and I sensed they were peaking.
That trade locked in annualized gains of 23% (not too bad!)
It looks like we may get another “bite at the cherry”:
Feb 15 2023
At the time of writing, the ETF TLT is trading around $103 with the 10-year yield at 3.79%
However, should yields continue to rise – the TLT will once again move back below $100.
I would be comfortable buying the TLT anywhere in the realm of $95 to $97.
It could go lower… however we may not see it push $92.
If you are able to get positioned between $95 and $97… expect to hold the trade over the next 2 years.
Not only will you stand to enjoy a dividend of ~2.7% – it could easily realize capital appreciation of 25% should we fall into recession.
In other words, bond yields fall sharply as investors seek shelter.
That’s how I will be looking to trade the initial move higher in yields… followed by the flight to safety.
Putting it All Together
Let me close by saying predicting these things is very difficult.
My thesis of yields rising further before finding resistance in the second half of the year could be wrong.
That’s fine.
I don’t pretend to get every trade correct.
And maybe the ‘soft landing’ pundits will be correct and we avoid recession.
That seems to be the consensus and perhaps why equities are rallying.
I think that is a lower probability outcome.
My view is the Fed will over tighten – raising the cash rate to at least 5.0% and holding it there for the balance of the year – inflicting acute pain on the economy.
As I said often last year – I think the economy will start to cry “uncle” once we start holding at or above 5.0%
However, the lag effect of these rates won’t be felt until the second half.
That pain isn’t being (fully) felt yet.
But it will.
Keep an eye on the 10-year yield regardless.
For example, once these yields start challenging 4.0%, they represent a real alternative to stocks (especially given where the S&P 500 trades)
Now if the S&P 500 was trading “3600” – it’s a very different story. That’s where the risk/reward shifts back towards equities.
And why I was happy adding to risk in that zone last year.
Let’s see how we go… and I will let you know if I enter the trade.