What’s Going On With The 10-Year Treasury?

treasury inflation protected securitiesOne of the more crowded trades over the past twelve months has been a short (bet against) of treasuries. Popular consensus has been that the economy is in the process of bottoming out and that the Fed will ultimately bring QE to an end, ushering in a higher interest rate environment. Due to the inverse relationship between bond pricing and yields, the “shorts” expect interest rates to increase and bond prices to decrease.

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Following the Fed’s May 2013 “infamous” announcement and subsequent onset of the taper, the yield on the 10-year Treasury has climbed substantially off historic lows. Yet on two occasions now, over the past six months, the 10-Year has traded near the 3% mark, but has quickly bounced off it. January proved to be a very strong month for bonds, with the yield on the 10-year dropping off by around 40 basis points, or better than 10 percent.

Understanding The Dichotomy Of Today’s Bond Market

Despite the fact that the Fed has announced it will continue on with the taper (another $10 billion bond buy reduction in February), bond prices have strengthened, contrary to what one might have expected. The reason for the recent strength in bonds has been a short, but sharp sell off in the stock market. While perhaps not an ironclad rule, fears in equity markets tend to lead to strength in fixed income markets, especially Treasuries, as investors engage in a “flight to quality.”

So the ongoing taper, which is generally thought of as bearish for bonds, has been more  than offset by recent weakness in stocks. The pullback in stocks has not been a complete surprise given last year’s 30 percent rise and lack of robust, widespread corporate earnings growth and perceptions of a fragile economic recovery. I will note that as I write this column during the early afternoon of Tuesday, February 4, equity markets are trading higher and the 10-Year has lost a bit of ground with the yield rising above 2.6%, as one might expect.

Where Do We Go From Here?

While I’m loathe to make macroeconomic predictions, I have not bought into the prevailing negativity and “bubble” banter that has surrounded bonds for the past several years. So while I’m equally reluctant to opine as to whether the 10-Year heads all the way back to 2% or gallops back to 3% here during the early stages of 2014, I think the question deserves your consideration.

Certainly, continued sharp retracement in the stock market could present a continued bullish flight to quality for the bond market. And by the same token, continued stock weakness could be indicative of a recovery that is failing to gain traction. If the Fed takes the view that the recovery is spinning its wheels or not moving quickly enough, one should consider the possibility that the taper could be suspended and/or bond buying reaccelerated in the coming months.

The other side of the coin is that we are merely experiencing a near-term lull in a burgeoning secular bear market for bonds and that the taper will quickly run its course, with higher rates all but assured in the years ahead. While I think that argument, which has been around for years, is logical given historically low interest rates, reality, and not logic, dictates the ultimate movement of asset pricing. Thus, to be a real bond bear, one must believe that a robust recovery is on the horizon. I personally don’t see it, with too many negatives – weak home pricing, rising food prices, the decline of the middle class, and a gridlocked Washington, amongst other things, collectively standing in the way of domestic strength.

Bond Strategy

Given the opportunity costs of going too long or staying too short in an uncertain forward yield climate, and recognizing that we live in rather unusual economic times, I think the average bond investor would do well to exercise a rather middle-of-the-road, all weather strategy. By this I mean looking at corporate credit in the BB/BBB range and  going out roughly 5-10 years to secure fair yields from well established companies.

I continue to feel that risk management should form the backbone of any bond investor’s portfolio. While there may be a bit of yield sacrifice involved, I don’t think it’s prudent to be swinging for the fences on long-term, low credit situations in this market, when you could end up striking out. On the other hand you don’t want to be bunting into short-term, low yielding, high credit situations, when your risk tolerance calls for something a bit more.

About the author:

aloisiAdam Aloisi has over two decades of experience investing in equities, bonds, and real estate. He has worked as an analyst/journalist with SageOnline Inc., Multex.com, and Reuters and has been a contributor to SeekingAlpha for better than two years. He resides in Pennsylvania with his wife and two children. In his free time you may find him discussing politics, playing golf, browsing antique shops, or traveling.

 

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