Treasurys and Stocks Cannot Both Continue To Rise

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Treasuries have evolved over the last 3 decades. In the early 1980s, the country had a terrible recession, high unemployment (even higher than today) and extraordinary inflation rates in double digits which drove interest rates into double digits. The Treasury sold a 30 year bond with a 14% coupon that turned out to be a good investment for those brave enough (and rich enough) to buy and hold to maturity.

Inflation and interest rates dropped, but in the 1990s were still at high levels with yields largely between 5-7% for the 10 year bond (TNX). Stock markets went through a brutal time at the start of this decade; those yields fell to a low of 3% in 2003.

Since then the long bond rates have been around 4% until the beginning of the financial crisis in late 2008. When it seemed like the financial system might collapse, yields on the Treasury bond plunged to a record low of 2% in early 2009 from a high of 5¼% in the middle of 2007. As the financial crisis eased, the rate returned to 3+%.

In the last 6 months there has been another plunge in yields on the 10 year Treasury from 4% to only 2½% even though the financial crisis is largely over. Current annualized yields for popular Treasuries are (as of October 1, 2010):

  • 3-month___0.15%
  • 2-year____0.42%
  • 10-year___2.52%

Risk averse thinking has returned to investment markets. These investors are buying Treasuries and gold (the ultimate safe haven investment). A 2 year $1000 Treasury note pays less than $9 in interest over 2 years. The 10 year bond provides a meager 2½% annually to cover inflation and a reward for owning the security. A desire for safety overwhelms the need to earn an adequate rate of return. By default, inflation concerns are minimal even though the federal government is running massive deficits.

At the same time other investors are buying stocks with an emphasis on higher yields (MLPs, REITs, junk bond funds, etc.). MLPs are at record levels while other high yielding groups are at interim highs. Caution has become a secondary consideration for these investors.

The major disconnect between growing demand for risk averse securities (Treasuries and gold) and high yielding stocks is disconcerting. This relationship was not made to last, especially with a federal government running massive deficits. Current low interest rates are also based on low inflation expectations and a sluggish economic rebound not making excessive demands for capital, again not encouraging for improving stock prices.

A strong economic recovery could lead to higher interest rates and a decline in bond values. Higher interest rates can bring problems for stock markets by drawing money away from stocks into bonds with more attractive yields. Investors would demand higher yields for MLPs, along with REIT and junk bond fund stocks, bringing down prices. Stocks had an excellent quarter in Q3 (especially in September), along with rising prices for Treasuries, gold and MLPs.

This begs the question: How long can risk averse and risk embracing investors profit simultaneously?

Disclosure: No position