At the beginning of 2015, I faced major backlash from people who questioned my view that the longer termed US Treasuries should be a core position in fixed income portfolios. After all, the Federal Reserve had finally indicated a desire to raise rates and the duration risk posed by longer dated bonds made my view quite debatable. Regardless, I stuck to my research, arguing that the global economy was not healthy and the divergence in monetary policies would make long bonds in USD much more attractive than emerging market or European debt. By now, we all know the rest of the story. Reflexive and relative is how this game is played.
This week we are faced once again with the immediate threat of higher rates in the US, at a time that some of us believe is just plain ludicrous. You name it: employment growth is starting to wane, real estate prices are topping (if not falling in key markets), energy companies are filing for bankruptcy, manufacturing is clearly in recession and the Affordable Care Act is beginning to prove more expensive than Obama promised. So, the question remains, what effect will rising interest rates have on long bonds? Better yet, what does it mean for the US yield curve?
To keep the story short, the trend towards a flatter yield curve is firmly in place. The market may discount the pace of rate rises, but it most definitely considers rate rises to be detrimental to the economy. It is common knowledge that Yellen, et al, are looking for the opportunity to raise rates. After all, they have very few arrows in their quiver and NIRP is something they are loathe to implement. Thus, it is quite telling that the spread between the US 30-year and the US 2-year continues to compress. Many forget that a change in short term rates does not imply a proportional move across the curve. Granted, it is still far away from being an inverted curve, but if US equities begin to price in a sharp economic deceleration, from the snail’s pace the US is presently at, you will continue to find better value at the long end of the yield curve. Just remember what happened in January.