Start Buying T-Bills Now

by: WWS Swiss Financial Consulting SA

The Fed is hawkish.

Yields will increase as bond prices fall.

Stocks still have a bit to run.

Investors should start buying Treasury paper now as the basic Fed interest rate is currently 2.00% to 2.25% after the 25bps rate rise of 26 September 2018. Caution is advised as further rate hikes will result in longer-term debt instruments losing value on paper. The question is rather how much in one`s portfolio should be exposed to the “risk” of continuing rate hikes since it is highly likely that there will be another rate hike in December and possibly three more in 2019 if there is no recession, stock market crash, black swan event or something else that could spook the FOMC.

To have a clear idea of what is happening, it is useful to look at things from a historical perspective. The chart below traces the spread (difference) between the yield of the Treasury five-year note and the yield of the thirty-year Treasury bond. When the spread is very little, that means that the yield of the shorter term note is almost as high as the yield on the longer-term bond.

A flattening yield curve means that the spread between the shorter-term investment and the longer-term investment is becoming less. Normally the longer–term investment should yield more than the shorter-term investment because of the risk involved in holding a debt instrument over a longer period of time. Inversion of the yield curve means that the short-term investment yield is higher than the yield of the long-term investment. The usual benchmark is the spread between the two-year Treasury note and the ten-year Treasury note.

At the present time the spread is very small and with the most recent Fed interest rate hike and another rate hike in December highly likely, it is probable that there will be an inversion of the yield curve in 2019. That means that holding shorter-term paper will yield more than holding longer-term paper. The result will be a decrease in the prices of longer-term bonds in order to compensate for the higher yield for short-term debt instruments. The purchase price on the secondary market for longer-term paper goes down as the yield of new issues increases.

For an investor that has done well with the stock market since the GFC, it could be time to start moving capital from equities to fixed income. Since the stock markets are flying high and it is likely that there is still enough momentum and optimism for the markets to go even higher but not very much higher, one could start implementing a defensive strategy by increasing the amount of capital in T-bills. for example, while selling the stocks that are not performing well in addition to taking profits from those that have performed well. FOMO (Fear Of Missing Out) should not stop an investor from taking definsive measures.

The prime questions in this respect are timing and quantity. There are, obviously, numerous factors that could influence the markets, one of which is the trade war between the US and China since that will probably result in higher inflation that will spur the Fed to continue raising interest rates. There is as well the possibility of the market topping out and then retrenching to consolidate gains. In any case, with short-term fixed-interest paper yielding more than 2% to 2.25%, it makes sense to sift out losers from one`s portfolio and play it safe with Treasuries. The problem is that all the longer-term Treasuries bought right now will go down in price as the Fed carries on with its normalization plans (see above) and raises interest rates still more. The consensus seems to be that the Fed will stop raising rates when the “normal” rate is reached. That may be between 3% and 3.5% if Fed dots can be relied upon.

What is “normal” and what is “neutral” for interest rates is a good question. For the Fed, “neutral” now means a Fed interest rate that neither hinders the economy nor promotes a bubble. This is currently considered to be between 3% and 3.5%. “Normal” rates before the GFC and the crash in 2000 were 4% or more. See the chart below.

United States Fed Funds Rate

From a historical perspective the ZIRP (Zero Interest Rate Policy) and NIRP (Negative Interest Rate Policy) environment since 2008 meant that new T-bill, -note and -bond issues had very low interest rates. One result was that managers of bond funds seemed to be geniuses as the value on paper of their AUM increased tremendously. The only way to make money in a NIRP and ZIRP environment was to concentrate on paper that had a near maturity date. Bonds on the whole were a very poor investment vehicle. A return of 0.5% or even less is not very attractive.

On the other hand, the low interest rate environment encouraged corporations to borrow money that was then used to promote share buyback programmes that resulted in higher equity prices. This pleased shareholders and made company executives rich as their stock options received as part of their remuneration helped them to reap great financial rewards. Companies also devoted a large share of profits into share buybacks while neglecting Capex (Capital Expenditure) and R & D (Research and Development). Investors following the stock markets saw their holdings increase in value with practically no consequential draw downs. This was not good for the economy as it meant that companies were not planning how to strengthen themselves for the future but were more intent on reaping short-term gains from financialization.

However, now the situation is changing. It is no accident that so much attention is focused on the FOMC and Fed decisions to raise interest rates. It is known that Fed interest-raising programmes bring about recessions. There is an excellent article in Investopedia that goes into detail precisely on this topic.

What investors should conclude from all this is that the tipping point will soon be reached where holding Treasuries as well as IG (Investment Grade) corporate bonds is soon going to be profitable again. However, because the Fed is still busy raising interest rates, it is advisable to invest in short-term debt instruments, and that means T-bills with a duration of four weeks or thirteen weeks. The 26-week or 52-week T-bills mean that the investor is exposed to a short-term paper loss because of interest rate rises before maturity. It should be taken into account that T-bills are purchased at a price lower than the value at maturity. The difference between the purhase price and the value at maturity is the "interest". Longer-term T-notes and T-bonds as well as IG (Investment Grade) and HY (HIgh Yield or "junk") bonds expose the investor to losses on paper as interest rates rise thanks to the Fed. The old 60%-40% portfolio allocation of bonds and equities may soon become the norm once more although up-to-date portfolios also include precious metals and commodities and derivatives for the sophisticated. If there is a recession and companies no longer have funds to finance share buyback programmes due to shrinking profits and higher financing costs, the stock markets will suffer as indicated by The Heisenberg in various Seeking Alpha articles. Bondholders will be earning interest on their holdings while shareholders will realize that Wall Street vendors are interested in selling stocks to make commissions and do not really care if their clients/customers are making prudent investments.

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.