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Dear Red Alert Reader,
The prospect of another $1.9 trillion in stimulus has markets rallying from last week’s turbulence, and the selling in Treasuries has cooled off a bit, but the forces that led to last week’s dual bond- and stock-market tantrums haven’t necessarily gone away.
I’m not here to burst anyone’s bubble; I’m cheering hard for this rally and even harder for economic recovery.
But there’s no getting around the fact that that same economic recovery also has investors nervous about the return of the “I-word,” with all that that entails for markets. I’ll show you why in a minute.
There’s a chance that over the next few days and weeks, we could see Treasury yields move up again.
But there’s no need to worry. I’ve got two specific moves in mind. The best part is, even if yields don’t jump as dramatically as they did last week, this should still pay off nicely…
How Rates Got So Low in the First Place
The Fed Funds rate gets all the attention because it’s the short-term interbank rate with which the Fed, frankly, manipulates the Treasury’s borrowing cost for 10-year loans. But make no mistake: The 10-year Treasury yield is the bond market’s benchmark. It’s the number the pros watch.
On March 2, 2019, long before any of us had heard the words “novel coronavirus,” the yield on the 10-year Treasury bond, or “note,” or “paper,” if you prefer, was 2.62%.
By this time last year, on March 2, 2020, as COVID-19 was upending life and demolishing markets, yields had fallen to 0.74%. Bonds were about the only thing that wasn’t selling off.
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When markets seized up with pandemic panic, the Fed jumped into action, unleashing a veritable flood of liquidity measure, such that by March 9 of that year, 10-year yields had fallen, briefly, as low as 0.318% – levels not seen since the darkest days of World War II.
Of course, as we all know, by March 24, 2020, equities, buoyed by all-time low rates and a concomitant flood of new, mobile-app based retail investors, took off like a shot. Not long after, and faster than most imagined, economic prints began to look better as we emerged from the “instant recession.”
Rates were still historically low; from March through the end of September 2020, 10-year note yields averaged just 0.65%. But that crept up and up over the months that followed; 0.88% by Nov. 1, 0.93% by the end of December 2020, and, by the end of January 2021, it was up to 1.11%.
Last week, lots of “pandemic stocks” sold off and “recovery stocks” rose, and yields briefly hit a 12-month high of more than 1.6%. Just yesterday morning, the 10-year yield hit 1.45% before settling down a bit.
But the Fed certainly hasn’t backed off its $80 billion monthly buying binge of government bills, bonds, and notes. The Fed Funds rate hasn’t moved off the “zero bound,” either. That zero bound is technically 0.00% to 0.25%. Compare that to 1.75% before the COVID-19 crash.
So, why’s the Treasury 10-year yield up lately?
Here’s Why Rates Are Higher Now
As political mastermind James Carville reminded presidential candidate Bill Clinton back in 1992… “It’s the economy, stupid.”
As in, the economy’s humming along nicely, thank you very much. We’ve seen money pour into energy, travel and leisure, metals, cyclical stocks – all indications of a strengthening economy. (I’m actually projecting a $353 billion wave of capital might hit some very specific stocks – you can hear more about that “Hyperdrive” event here.)
At the same time, there’s a flood of liquidity drenching every sector of the economy, and every corner of every market for every asset class. So, naturally, investors are starting to worry that inflation might be right around the corner.
On paper, it’s not an unreasonable fear.
Inflation, in a nutshell, means rising prices. Those usually follow on the heels of an expanding money supply. Rising prices and an expanding economy run smack into each other, with troublesome results. And to say the Fed is “expanding the money supply” is like saying “the Grand Canyon is a ditch.”
One manifestation of inflation, or, sometimes, just the anticipation of inflation, is rising rates. When prices rise, things cost more, so workers demand higher wages to pay for them. The more money workers have to spend, the more producers of goods and services can charge, hence more rising prices.
As the demand for money increases, rates rise because banks can charge more for loans. The cost of money is reflected in interest rates.
And that has an impact.
When Rates Rise, Lots of Things Happen
For investors, the choice of putting money in equities versus bonds or fixed-income investments gets upended. Higher rates tend to lure more investors out of equities and into safer fixed-income alternatives. So, despite the fact that the economy is expanding, one drawback of rising rates could be a stock market sell-off.
Another dangerous thing happens when rates rise. Bond investors see the prices of their fixed-income holdings, especially all those low-yielding bonds investors bought (because they had no choice), begin to fall. When rates rise and prices fall, the relationship is said to be “inverse.” Prices of existing fixed-income investments fall because investors sell them to buy new, higher-yielding paper.
That takes us back to the 10-year notes. The yield on these Treasuries rises rapidly as a function of investors not really wanting to buy or hold it, if rates are going to rise. By selling 10-year bonds, or at least not buying what the government is issuing, the rate will keep rising, which, in turn, signals to other investors that inflation may be in the mail.
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Now, to be perfectly clear, none of that is happening right now, but economists and analysts are starting to talk about it. Investors can hear this, and they’re worried we’ll see inflationary effects this year as the economy continues expanding.
For investors right now, there’s a tension between the improving economy and the prospect of the end of the pandemic – all good – and the risks of inflation – not so good.
It’s like a pendulum.
We saw that swing in action yesterday to the upside. 10-year Treasury yields remained above 1.4%, but stocks enjoyed a nice, broad rally as hopes for a recovery and warm, fuzzy thoughts of stimulus banished the inflation boogeyman – at least for the session.
The pendulum could easily swing back the other way, though. The good news is, there are some really easy, inexpensive moves to make when that happens.
How to Profit When Yields Creep Up
I happen to believe that, if the specter of inflation is out there, we’re not likely to run into it for a few quarters at least.
When rates rise, think of the ProShares UltraShort 20+ Year Treasury ETF (NYSEArca: TBT), which rises as rates rise and bond prices fall. TBT is a leveraged exchange-traded fund, which means it rises three times as high as bond prices fall; this makes it much better for short-term trading than long-term holding. The ETF hit a high of $21.22 last week, on Feb. 25. It opened quite a bit lower yesterday morning, below $19.65, but went up to nearly $20.50 by midday; folks who were trading that the right way, with options, would’ve had a good day’s haul.
It’s possible to play the 10-year Treasury even more directly, with the iShares 20+ Year Treasury Bond ETF (NASDAQ: TLT). It goes down when rates go up, so, in a rising-rate environment, it makes good sense to trade puts on it.
Stocks may have been up yesterday; optimism won out over inflation fears for the day. But I’m betting we’re going to see rates rise before they come down much, so TLT and TBT make good sense right now.
Profit potential at a time like this is all about being “in position,” so that you can be where the opportunities will be.
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