Last week, the yield on 10-year Treasuries hit the 3% mark… and it’s stayed around that level.
While this is still a very low rate by historical standards, it’s a tick up from what we have seen over the last couple of years.
(I like to track the 10-year yield because it gives a good idea of interest rates in the longer term. It also typically provides the best correlation with mortgage rates.)
The 10-year yield very briefly touched 3% in September before sinking back down. But aside from that brief period, we haven’t seen 3% since July 2011.
It is hard to believe that just back in May of 2013 — when we saw record-low mortgage rates — yield was close to 1.6%. But then the talk of a Fed “taper” began, and with that, yield started to rise.
Ironically, with all of the taper talk we’ve been hearing, we are just now seeing the beginning of the actual taper — and it is only by $10 billion per month. The Fed will create $75 billion per month out of thin air instead of $85 billion.
Betting on Higher Interest Rates
A short position in bonds certainly would have done well in the last 7 months. And while some analysts think yields will continue to rise, I am not confident enough to recommend a short position in bonds right now (which would be a bet on higher interest rates).
If you disagree and think it is time to bet on significantly higher rates, you can buy a mutual fund or exchange-traded fund such as TBT (NYSE: TBT), which shorts long-term Treasuries.
But I think there are too many variables at this point. Janet Yellen will take the helm at the Fed at the end of the month, and we have no idea if the Fed will continue to taper or wait and see…
If the economy shows signs of a downturn, we could easily see investors flee to safety and drive yields back down. We could also see the Fed start an expanded QE program (more money-creation) and quickly revive the bond market.
I am not saying this will happen — only that it is a reasonable possibility at this point.
I don’t necessarily agree with the reputation given to government bonds as a safe haven, but I realize many investors view them this way…
Consumer Price Inflation (CPI)
Personally, I will not bet against bonds until I see significantly higher consumer price inflation. Until then, I do not expect the Fed to let the bond market sink too much.
The Fed might tolerate seeing rates go up to 3.5% or even 4%, and the economy may be able to take this. It will not mean too dramatic of a rise in mortgage rates.
But I don’t think the Fed will tolerate spiking rates, especially if it happens quickly. This could really spell bad news for the entire economy, and the Fed would likely try to mask this by pushing rates back down.
Therefore, the only scenario in which I see rates spiking significantly and the Fed not stepping in is if the Fed is also really concerned about high price inflation.
And at this point, the Fed is not. Instead, it’s creating massive amounts of money and basically getting away with it. It’s enjoying a free lunch.
If we were to hit a point where the CPI were rising at, say, 5%, then it would be a whole different ballgame. This would mean the Fed would have to be concerned about rising consumer prices as opposed to rising asset prices, which is what we see now.
But Janet Yellen will be in the top spot at the Fed, and she is known as an inflation “dove.” Maybe a CPI reading of 5% won’t bother her too much. Maybe it will take 10% or more before she folds…
Either way, higher expected inflation will likely lead to higher interest rates. If an investor is going to buy a bond with a 10-year maturity, he is going to demand a higher interest rate if he thinks his money is only going to be worth half its value in 10 years when the bond matures.
Therefore, interest rates — including the 10-year yield — will go up to compensate for the expected inflation.
This is what we saw in the 1970s when there was double-digit price inflation and double-digit interest rates. The interest rates did not come back down until Paul Volcker’s Fed slammed on the monetary brakes. Once investors took it seriously and realized price inflation would come down, bond prices went up alongside falling interest rates.
We Need More Fear
At some point, the game will come to an end. The Fed will have to make a choice of whether to keep inflating or to stop.
But until we see higher CPI numbers, I don’t see the Fed stopping…
Therefore, I am not betting on significantly higher rates at this point in time, though I might reconsider down the road.
It’s not enough that I expect higher price inflation in the future. I need to expect that other investors will expect this too. Until there is more fear of inflation, I am not shorting bonds.
I am not betting on lower interest rates at this point, either. I don’t think the opportunity is there yet to make a big bet on bonds either way.
There may come a time in the future when it would be very profitable to bet on higher interest rates…
But until then, I will find other places for my money.
Until next time,
Geoffrey Pike for Wealth Daily
