Why The 10-Year Treasury Is Likely Headed To 3%

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Includes: ACP, AIF, ANGL, ARDC, BIL, BSJP, CIF, CIK, CJNK, CLTL, DB, DFVL, DFVS, DHY, DLBS, DSU, DTUL, DTUS, DTYL, DTYS, EAD, EDV, EGF, EUFL, EUFN, FALN, FIBR, FLAT, GBIL, GGM, GOVT, GSY, HIX, HYDB, HYDD, HYG, HYIH, HYLB, HYLD, HYLS, HYT, HYUP, HYXE, IEF, IEI, ITE, IVH, JNK, JQC, JSD, KIO, MCI, MPV, NHS, OPER, PCF, PHT, PLW, PST, RISE, SCHO, SCHR, SHV, SHY, SJB, SPTL, SPTS, STPP, TAPR, TBF, TBT, TBX, TFLO, TLH, TLT, TMF, TMV, TTT, TUZ, TYBS, TYD, TYNS, TYO, UBT, UJB, USFR, USHY, UST, USTB, VGIT, VGLT, VGSH, VLT, VRIG, VUSTX, WFHY, ZROZ
by: Ivan Martchev
Summary

When it comes to investors in risk assets, the Chinese trade deal and the Federal Reserve are the top two concerns.

The stock market is doing well as the friction between the White House and the Federal Reserve has been dramatically toned down since Christmas Eve.

Interest rates in Europe are really low, and demand for Treasuries should be strong despite the record issuance, so 3% is a likely target without overshooting too much.

Even with Kim pulling off a switcheroo on President Trump in Hanoi last week, the stock market had very little negative reaction. A failed nuclear summit that had a lot of potential to ratchet down tensions on the Korean peninsula is disappointing, but the stock market took it like a champ.

Still, I would characterize the friction with Kim as a secondary concern for the moment, when it comes to investors in risk assets, while the Chinese trade deal and the Federal Reserve would be the top two concerns. The stock market is doing well as the friction between the White House and the Federal Reserve has been dramatically toned down since Christmas Eve.

Also, preparations are taking place for a summit between President Trump and President Xi Jinping to sign a trade deal at Mar-a-Lago, where President Xi will be treated with respect, which is very important for the Chinese public. Saving face is more important to the Chinese than tweeting with impunity is for President Trump. It takes an unconventional Twitter connoisseur to get a hardline Sun Tzu disciple to do a trade deal in the present interesting times. Never take negotiations as a foregone conclusion, as per Kim’s maneuvers, but it looks like the trade deal will get done.

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Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The nearly-negotiated trade deal leaves a lot of the cards on the economy in the hands of the Federal Reserve. The implications for the historic Federal Reserve dovish pivot in late December and early January is that the yield curve may re-steepen, and the 10 year Treasury Yield is headed toward 3%.

Treasury 2-year notes should be a bit more anchored for the moment as they are more sensitive to Federal Reserve policy, namely the fed funds rate. As per the Fed Chairman’s admission that the FOMC is “patiently awaiting further clarity” when it comes to the Fed funds rate, the case for yield curve re-steepening is clear. A steepening of the yield curve should be good news for junk bonds, and stocks for that matter – or risk assets in general, which got killed in the 4th quarter.

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Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

It has to be noted that quantitative tightening continues as the Federal Reserve balance sheet keeps shrinking on schedule, so the fact that the Fed is not hiking the Fed funds rate does not mean that the Fed has stopped tightening. The lift of the cap on the balance sheet runoff rate from $20 billion to $50 billion in 2018 caused epic volatility in the stock market and, in that regard, it has to be closely monitored.

By the U.S. Treasury’s own admission, borrowing estimates for 1Q 2019 will be $385 billion. Borrowing estimates for the whole fiscal year is over $1.3 trillion. (1Q 2019 is a weak quarter for the Treasury as there are tax refunds issued, hence the borrowing needs are a little higher). By any yardstick, that's a lot of Treasury bonds coming soon, hence going up to 3% in yield is likely with a $50 billion cap on the Fed balance sheet. (A $50 billion balance sheet run off rate cap means that about $50 billion in demand for bonds – ⅔ Treasuries and ⅓ mortgages-- is removed from the market on a monthly basis).

U.S. Rates are the Highest in the Developed World

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Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

That said, the epic Brexit disaster has put the EU on the ropes again, with German 10-year bunds closing the week at 0.19%. My favorite 2-year bunds, technically called bundesschatzanweisungen, but dubbed schatze notes to avoid tongue injuries, closed the week at -0.53%, starting their fifth year in negative territory. The point is that interest rates in Europe are really low, and demand for Treasuries should be strong, despite the record issuance, so 3% is a likely target without necessarily overshooting too much.

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Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

European financials have trouble making money with such interest-rate differentials and the stock of the biggest bank in Germany and one of the biggest banks in the world – namely, Deutsche Bank (NYSE:DB) – looks worse than Lehman Brothers before it filed for bankruptcy in 2008. DB shares are 50% below their 2008 lows, when most financials saw share prices not seen in decades. The inability of many European financials to straighten out their business in this very low interest rate environment was recently called the “Japanification of European financials” by a famous investment strategist. This Japanification phenomenon should help Treasury yields behave in a year of record issuance like 2019.

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Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Taking a look at the latest trends from the largest junk bond ETF, the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA:HYG), StockCharts.com (above) makes adjustments for distributions, which are sizeable given the yield, so this is like a “total return” chart. Many other chart services do not include distributions, so the charts look very different. Be that as it may, investing is about total returns, and HYG is at a 52-week high. That tells me that the stock market is also likely headed to new highs.

Navellier & Associates does not own Deutsche Bank in managed accounts and a sub-advised mutual fund. Ivan Martchev and his family do not own Deutsche Bank in personal accounts.

Disclosure: *Navellier may hold securities in one or more investment strategies offered to its clients.

Disclaimer: Please click here for important disclosures located in the "About" section of the Navellier & Associates profile that accompany this article.

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.