Treasury Yields Are Heading Higher

| About: Vanguard Extended (EDV)

Summary

Government Bond Yields continue moving higher all around the World but the biggest increase took place in the US.

Investors now expect 1 to 2 Fed rate increases until the end of 2017 as well as a 50 basis point increase in the US Libor during the same period.

In this environment, you should favor floating rate notes, inflation linked bonds and corporate debt and avoid fixed interest rate Treasuries. Cash is also a valid option.

Where do we stand?

In a previous article, I've shared my view that Government bond yields in Japan, Germany and the US have bottomed and were starting a slow and long path of increases.

As we know, the increase in yields translates to a decrease in the price of bonds, and the longer the duration of your portfolio, the bigger the impact on bond prices. Looking at bonds maturing in at least 10 years, here's the average price impact of the increase in yields since mid-July:

Click to enlarge

Source: Bloomberg

The graph shows that all countries suffered from yield increases. It also highlights that monetary policy is turning less accommodative even in Japan (NYSEARCA:JGBS) (NYSEARCA:JGBD) (NYSEARCA:JGBL) (NYSEARCA:JGBT) (NASDAQ:JGBB) and the Euro Area (NYSEARCA:BUNL) (NYSEARCA:BUNT). Finally, it comes with no surprise that the biggest jump in Government bond yields took place in the US (TLT) (TBT) (TMV) (IEF) (SHY) (TBF) (EDV), where the Fed has been threatening about interest rate increases for months.

Looking at the 10-year US Treasury yield, we're now 40 basis points higher than the all-time low registered during the first week of July. The 1.75% resistance won't break easily though, because it corresponds to the support level seen during the 1st half of 2016 and the truth is that we didn't have any Fed rate hike yet. Still, I don't agree with the view that yields will consolidate back to 1.50% (or lower). Instead, I think we'll stay close to 1.75% at least until the election and then jump higher before the FOMC December meeting (but more on that later).

Click to enlarge

Source: Investing

In another article, I also warned that the US Libor was rising, supporting the movement in the same direction of Treasury yields. Click to enlarge

Source: Trading Economics

Where are yields heading to?

The previous chapter was backward looking. Now, it's time to look forward and the big question is: will yields continue to move higher or are they heading lower once again?

Some investors see this as a buy opportunity, but I don't share that view. As I mentioned earlier, the key is in breaking the 1.75% yield on 10-year Treasuries and my view is that we'll break through that level before the end of the year, here's why.

To start with, the probability of a Fed rate hike in December 2016 is now over 60%. The likelihood that the Fed funds rate will reach 1% by the end of 2017 has also been increasing recently.

Click to enlarge

Source: Bloomberg

Furthermore, the market is also forecasting the US Libor to move higher over the next 15 months from 0.9% today to 1.4% by the end of 2017. That's a 50 basis point increase. This supports the view of at least 2 Fed rate hikes over the next 15 months: one probably in December 2016 and at least one during the year of 2017. Click to enlarge

Source: Bloomberg

What to do?

Cash is not a bad option at the time being, here's why.

Let's say the 10-year Treasury yield rises 25 basis points over the next 12 months from 1.75% to 2.0%. In October 2017, you would have earned 1.75% in interests but you would have lost roughly 2.25% on your bond price (9-year duration x 0.25%). Putting the two sources of return together, you will lose 0.50% over the next 12 months.

But that is in case of a 25 basis point movement in 10-year Treasury yields. Would the increase be more pronounced, let's say a 50 basis points increase over the next 12 months to 2.25%, and you would lose 2.75% in one-year's time (+1.75% interest - 4.5% bond price loss).

In fact, we can't forget that Government bond yields are at unprecedented low levels. This means that what you'll gain in interest in one year won't be enough to compensate for the loss you'll have in your bond price during the same period. That is different from what investors are used to, because in the past, the interest received more than compensated for the loss in the price of the bond. That's why, cash seems better than US Treasuries at the time being.

Another alternative is to buy floating rate notes or inflation-linked bonds instead of fixed interest rate debt. In both cases, your bond prices won't be affected by the increase in interest rates or the inflation, so you're more likely to end up with a positive return in 12 months' time. If you have to choose between them, I prefer the inflation linked bonds because despite the rate increases, Central Banks are pursuing negative real interest rate policies. This means that the Fed funds rate will remain below the inflation rate in the years to come.

Finally, you can also buy corporate bonds, where the yield is composed both by the risk-free rate (US treasuries) and the credit spread of each issuer. This way, even if the risk-free rate increases, you'll probably end up with a positive return in one-year's time, ceteris paribus (the credit spread remaining stable), here's why.

Let' say you buy a 10-year corporate bond yielding 3.0% (that's 1.75% risk-free rate plus 1.25% credit spread). If the risk-free rate increases 25 basis points to 2.0% and the credit spread remains stable, that will total a 3.25% yield. In October 2017, you would have earned 3.0% in interests but you would have lost roughly 2.25% on your bond price (9-year duration x 0.25%). Putting the 2 sources of return together, you will gain 0.75% over the next 12 months.

In Summary

US Treasury yields are heading higher and will continue to move upwards over the next 12 months.

In this kind of environment, you should avoid fixed interest rate Treasuries and favor floating rate notes, inflation linked bonds or corporate bonds. Cash is also a better alternative than fixed interest rate Treasuries.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.