LONG 10Y TREASURIES
Within the world's major economies there are divergent monetary policies. The major global economies are moving in opposite directions. The economic recoveries within the US and UK should soon lead to interest rate rises and tighter monetary policy. However, the Eurozone, Japanese and Chinese central banks are pursuing looser monetary policy. The Eurozone and Japan economies are continuing to struggle and their central banks are either implementing Quantitative Easing (QE), for the first time, as in the case of the Eurozone, or have just increased QE. As the Chinese economy slows down, the People's Bank of China is also pursuing a looser monetary policy with a cut in interest rates, which should support their economy.
How to invest...U.S. Treasury securities including Treasury bonds are viewed as one of the safest investment options. The major risk involved with Treasury bonds is interest rate risk -- the change in bond values when interest rates change. Interest rate risk affects the value of bonds more directly than stocks, and it is a major risk to all bondholders.
Federal Reservers' (Fed) Chair Janet Yellen is not expected to take hawkish actions until unemployment rates are well down. Please see below the relation to the Phillips Curve.
A decreased unemployment, (i.e., increased levels of employment) in an economy will correlate with higher rates of inflation. While there is a short run tradeoff between unemployment and inflation, it has not been observed in the long run.
In 1968, at the height of the Phillips Curve's influence, Friedman gave the Presidential lecture to the American Economic Association titled The Role of Monetary Policy. The Curve was nonsense, he said, at least in anything but the very short term.
The Fed in the US is not under inflationary pressure to raise rates due to the strength of the dollar and the historic fall in oil prices. Yellen cited Fed policymakers' forecasts that inflation will reach 1.7% to 2% by the end of 2016, up from a projected 1% to 1.6% by the end of this year 2015.
The macro economic impact of falling oil prices is a lower inflation and a higher output.
This diagram shows that a fall in oil prices (and a fall in firms costs) will shift Short Run Aggregate Supply (SRAS) to the right, causing lower inflation and higher real GDP. Furthermore some economics pointed out that a 10% fall in oil prices leads to a 0.1% increase in GDP. Therefore, we might see a delayed rate hike in the US or very small hikes during 2015.
This explains why the US 10-year Treasury bonds are back down to 1.8416 percent for now (April 2015).
In May 2013, Ben S. Bernanke made his initial announcement about tapering us 10-year treasury bond yields to 3 percent (an almost 100 percent increase). Now, the tapering is officially over but the Treasury yield is back down to 1.84 percent, contrary to all experts' expectations. Most analysts still predict Treasury yields to exceed 3 percent in 2015, when the Federal Reserve's first interest rate hike is expected.
Higher interest rates tend to mean higher economic growth, which hopefully will translate into better employment prospects and an improvement in real wage growth. If, after a long time of zero percent interest rates, the Fed finally raises rates, it will likely mean that we are finally seeing an improvement in the real economy and not just the stock market. By moving interest rate targets up or down, the Fed attempts to achieve maximum employment, stable prices and stable economic growth.
As the U.S. economy continues on its steady, moderate growth trajectory and the Federal Reserve's wave of quantitative easing (QE) asset purchases comes to an end, a question at the forefront of investors' minds is how to position portfolios for the rise in interest rates that is likely to follow. It's not uncommon to hear that if interest rates are expected to rise, then active treasury management is sure to outperform (long 10y Treasuries).
The 10-year treasury is a debt obligation issued by the United States Treasury Department with a 10-year maturity. It is the most popular type of US Treasury debt and is often used as a barometer for the overall U.S. economy. The main factors generally affecting the U.S. Treasury market are the overall U.S. economic outlook, the pace of GDP growth and inflation. The 10-year Treasury Bond gives an indication of how much return investors require to tie up their money for 10 years. If investors think the economy will be bullish over the next decade, they will require a higher yield to keep their money tied up in bonds. When there is a lot of uncertainty in the market, they don't require quite so much to keep their money safe.
However, even the Federal Reserve watches the 10-year Treasury rate before making its decision to change the Fed fund rate. That's because the 10-year Treasury note, like all other Treasuries, is sold at an auction.
Therefore, the rate indicates the confidence that investors have in economic growth. Europe (BATS:EZU) and Japan (NYSEARCA:EWJ) have yields at near-zero levels. The US looks comparatively better with ten-year Treasury yields (NYSEARCA:IEF)(NYSEARCA:TLT) hovering around 2%. However, this is still much lower than the historical averages. You can see this in the previous graph. The robust US economy, along with political and economic uncertainty in other parts of the world, caused investors to climb into US fixed income instruments.
SHORT 10Y GERMAN BUND FUTURE
Are there any relationship exists between interest rate increases and equity movement There's been a few recent studies that identified a multivariate effect, with rising stock prices correlated with rising interest rates up to about 5%-6%, then falling stock prices above 6%.
In fact, this effect was seen in the last two episodes of Fed tightening but there's just too much variation in the relationship between rising interest rates and stock prices to know for sure.
The chart below shows what the distribution of historical correlations looked like in one recent study from 1963-2014. At bond yields below 5%, rising rates were associated with rising stock prices, but above 5%-6% rising rates meant falling stock prices.
However, J.P. Morgan Asset Management looked at the relationship between the 10-year Treasury yield and the Standard & Poor's 500 index over the past years, and the results were not what is expected. Instead of seeing a negative relationship, they actually found there was a strong positive relationship. When the 10-year Treasury yield was below 5 percent, rising interest rates were generally associated with rising stock prices.
Many investors and traders often have to employ hedging strategies in order to counterbalance high volatility environments that frequently hit equity indices. The asset classes that are normally selected to stabilize portfolio risk go from currencies to commodities or alternative forms of investment. Nevertheless, the most popular tool employed to reduce the volatility of a portfolio remains the bond market like the German Bund futures.
As we can see, the core American equity index has a robust negative correlation to German Bund futures and an almost inexistent connection to Treasury Bond futures. See the chart German Bund (FGBL, Candlestick) and S&P500 (Colored line).
The calculation highlights that long-term investors and portfolio managers would be better off using German Bund rather than other forms of investments to minimize oscillations deriving from their S&P500 positions.
In conclusion, shorting German Bund futures proved to be a more efficient and better tool to hedge long positions on Treasury Bonds.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.