Win McNamee
When the United States 10-Year Bond Yield (US10Y) broke through 5% I didn’t go straight-up long. That would have been the best thing, but at least I decreased my short position because bonds have gone on a run:
Inflation has been coming down persistently. That didn’t surprise anyone, me included. However, I expected inflation to start bouncing off 2-3%. With supply chain problems easing and energy prices deflating, the first part was predictably easy. The rate at which it is coming down is slowing:
The market had been pricing in rate cuts up to yields of 5%. At the December 13 meeting, there was an expectation that Fed Chair Jerome Powell would harp on about the need to stay “higher for longer.” Meaning, it is important to keep interest rates high for a long period of time. Instead, he answered a question like this:
…we believe that we are likely at or near the peak rate for this cycle. Participants didn’t write down additional hikes that we believe are likely, so that’s what we wrote down. But participants also didn’t want to take the possibility of further hikes off the table. So that’s really what we were thinking…
The CME FedWatch Tool shows the market now believes it is likely we’ll have ~1.25-1.5% lower rates by next December. Not to mention, the probability of rates increasing is deemed zero:
CME FedWatch Tool (CME)
This could happen because we’re only now starting to see signs of the U.S. economy weakening. Powell said it as follows:
Recent indicators suggest that growth of economic activity has slowed from its strong pace in the third quarter. Job gains have moderated since earlier in the year but remain strong, and the unemployment rate has remained low. Inflation has eased over the past year but remains elevated.
The U.S. banking system is sound and resilient. Tighter financial and credit conditions for households and businesses are likely to weigh on economic activity, hiring, and inflation.
If we’re now seeing the tightening show up in the real economy, things could deteriorate rapidly because the Fed went on a historically fast-hiking campaign:
This was accompanied by quantitative tightening, which studies suggest is equivalent to additional rate hikes. It makes sense that it is in some sense tightening financial conditions. If this is all now starting to come through, we could suddenly face a sharp decline in the economy. The market may be anticipating something to that effect.
I can see the current trend continues. The long bond positions have the trend on their side and more and there is a general feeling that yields have fallen a bit too fast. I’m not certain enough to go long bonds. I did close out my bond shorts except when they were hedges.
When I look at the yield curve I’m not sure if it seems to me that the short-dated bills are very unlikely to be a bad bet. The worst case with these is likely the opportunity cost of potentially holding something better. 1-3 month bills are yielding above 5.4%. The longer-dated stuff is all pricing in rate cuts. I can see these rate cuts coming. They could even exceed what’s priced in. However, I’m not convinced there can’t be a surprise the other way. Probably a lot of long bond positions will work in the near term, but I’m okay making 5.4% more or less risk-free.
U.S. yield curve (ustreasuryyieldcurve.com)
A solid vehicle to get 0-3 month treasury exposure is the iShares® 0-3 Month Treasury Bond ETF (NYSEARCA:SGOV) with $17.4 billion of assets under management. The 0.07% expense ratio is low. The effective duration for the fund is 0.09 which is quite a bit below its category average as well. The yield to maturity on the portfolio is 5.38%. The fund is 100% invested in government securities and distributes interest on a monthly basis.