Beware the Bond Bogeyman: He’s Coming to a Rally Near You

Shah Gilani Mar 02, 2021
4 

Just when you thought it was safe to invest in anything and ride the “everything rally” to the moon, the bond bogeyman raised his scary head last week and sent shivers down every market’s spine.

The yield on the Treasury 10-year note had been ticking up, from an average of 0.65% through last summer, to 0.85% by late November, to 1.11% at the end of January, to last week when it shot up to 1.61% on Thursday.

Where did this bogeyman come from? And what does he want?

Let’s find out…

Bond Investors Screaming Through the Decades: Real Rates Matter

The spike in the interest rate the U.S. Treasury pays investors on money it borrows for ten years last week wasn’t due to anything the Federal Reserve did, in fact, they freaked out like everyone else.

What happened, what’s been happening, is bond market investors and traders decided they were going to be heard, loud and clear, that they see the massive expansion in the money supply, with stimulus checks on top of that, and massive fiscal spending on top of that, and the economy expanding, leading to inflation, which eats into the real returns they expect to make on their bond holdings.

In fact, the echo of their collective voices could be heard from as far back as 2013, 2003, and all the way back to 1993, as they shouted to the Fed and the Treasury, and markets, real rates matter!

First off, there’s a big difference between real rates and nominal rates. Nominal rates are the stated rates of interest we always hear about. The yield, or nominal rate, on the 10-year Treasury being .65% last summer, or 1.10% percent in January are the headline numbers. But they are nominal, meaning named or in name only. The real yield or return on a fixed income investment, on a note or a bond, is the nominal rate minus the inflation rate. If the nominal rate on the 10-year Treasury is 1.45% (which it is today) and the rate of inflation is 2% (where the Fed’s trying to push it), then the real return on that 10-year investment is NEGATIVE .55% (1.45% minus 2.00%).

So, yeah, REAL RATES MATTER!

It’s the prospect of inflation ahead that’s motivating the bogeymen to act. They don’t want the Fed to keep rates across the yield-curve artificially low, and inflation to rise to 2%, or a lot higher, and eat into their real returns. So, they’re pushing rates up themselves.

The Federal Reserve can’t target all rates and manipulate them to where they want them. Their primary tool for influencing rates is the Federal Funds Rate, the interbank, overnight rate banks charge each other for loans they make to one another when they have more reserves than necessary in their vaults and want to lend them out and make some interest. The Fed targets the Fed Funds rate by announcing a range they want it to trade in, that range is currently 0.00% to 0.25%, and they manage it into that range by executing “open market operations” in the actual Fed Funds market. In other words, they buy and sell funds in the FF market, either adding funds to lower the rate, or extracting funds to raise the rate.

They don’t operate in the bond market the same way for all maturities, just in the Fed Funds market.

Investors and traders buy and sell all maturities of Treasury bills, notes, and bonds in the “bond market” every day, to the tune of more than $547 billion a day, according to Statista. Corporate bonds trade around $31 billion a day. But we’re talking Treasuries.

Since the Treasury 10-year note is the bond market’s benchmark, it used to be the 30-year bond, everyone’s hyper-focused on that yield. The yield’s been rising because investors and traders haven’t been buying as much as they normally do, and in fact are selling that maturity, which causes the yield to rise.

Last week, on Thursday, with the “inflation’s around the corner” narrative wafting through bond markets, and rates already rising, the Treasury auctioned off $62 billion of 7-year notes. It didn’t go well. The bid-to-cover ratio, how many bonds are bid for relative to how many are for sale, was 2.04, which turned out to be record low demand. Call it a buyers’ strike.

When that happened, the 5-year rate jumped, and the 10-year rate shot up to 1.61%. All that jumping higher freaked out stock market investors, who had been jumpy themselves watching the rate on the 10-year rise precipitously over the previous two weeks.

Rates rising are a problem for equity investors for several reasons. As rates rise investors start selling equities to move into better yielding fixed-income investments, which have less risk. Also, rising rates impact borrowing costs for corporations, whether that’s for debt management or to finance buybacks, it matters in terms of leverage, supporting stock price levels, and earnings per share metrics. And, rising interest rates impact the discounting math in valuation models, especially for tech companies’ earnings.

Back in 2013, when the Fed announced it was going to “taper” its purchases of Treasuries and mortgage-backed securities, which would cause rates to rise, the stock market freaked out and sold off. The so-called Taper Tantrum was a loud and clear message to the Fed that putting upward pressure on rates wouldn’t work for equity investors. The Fed got the message and stopped the taper.

In 2003, when rising rates triggered a “convexity” fueled rout, the 10-year rate rose 150 basis points, one and a half percentage points, in two months, causing huge bond market losses. Convexity hedging also contributed to the sharp selloff in Treasury bonds last week.

Convexity is the relationship between a mortgage portfolio’s average duration and rates. When rates rise the duration, or maturity, on a mortgage portfolio becomes longer, that’s because mortgage holders don’t refinance as much in a rising rate environment, which means the portfolio doesn’t turn over as much, hence its increasing maturity. Just as longer maturity bonds are more sensitive to rate changes, longer-duration mortgage portfolios become increasingly sensitive to rising rates. Portfolio managers hedge their rising exposure to rising rates by selling longer-dated Treasuries, often shorting them, to hedge themselves.

And back in 1993, so-called “bond vigilantes” went on strike refusing to buy all the debt the Treasury was issuing and drove the yield on the 10-year from 5.2% to 8% in about a year.

So, yeah, the bogeyman’s out there.

Next time, I’ll tell you what’s going to happen to every asset class in the everything rally if the vigilantes and bogyman don’t get their way.

But until then, there are ways to play ball with these bogeymen, ways they may not expect.

I’m going over 50+ stocks – some that I believe are real show-stopping, must-have stocks, and others that are bottom-of-the-barrel losers – in my 2021 Investors Address. With these stocks in your portfolio, I’m sure you’ll have everything you need for a chance to turn these volatile markets into cash in the bank.

And if you’re a notetaker like myself, I encourage you to use this sheet while you follow along, because there isn’t a single stock here you can afford to miss out on.

Warm wishes for health, wealth, and happiness,

Shah

4 replies on “Beware the Bond Bogeyman: He’s Coming to a Rally Near You”

  1. Doris Hendrickson says:

    I would like to be able to read the first book on his list of 5 when I first joined Precision that had the stock ID for the battery company started by the man who was in Tesla’s battery division for the million mile battery.. I am not good with tech stuff (born long ago without growing up learning this stuff) – please help me with the name of the battery company and stock symbol…

  2. JEFFREY MIRENDA says:

    Hi shah,my rally headed south my portfolio has lost thousands in the past week.I hope u have something good up your sleeve because I’m suffering.Didnt this happen last March with a black swan event?The old saying bonds up stock down.

  3. JEFFREY MIRENDA says:

    Need some guidance on what to buy now I’ve recently lost my shirt in this market and some the hyperactive plays didn’t do well at all.Now that prices are low what is the next move???

Leave a Reply

Your email address will not be published. Required fields are marked *