IEI: 0% Is The Next Destination For 3-10 Year Treasury Yields
Summary
- 10-year Treasury yields plunged under 1% as yield curve remains inverted despite Fed's emergency rate cut.
- Treasury yields will likely follow German bunds' footsteps 5 years ago and drop towards zero.
- Collapse in crude oil prices piles further pressure on bond yields due to higher risks of deflation.
- We expect steep declines in 3-7 year Treasury yields on a bull steepening yield curve, leading to further price gains in the corresponding ETF (IEI).
The verdict is in just days after Fed's 50bp emergency rate cut : It is not enough. Despite non-farm payroll number blowing out expectations, it was overshadowed by a spiraling coronavirus contagion which led to 10-year Treasury yields plunging below the key 1% level on Friday, while the yield curve remains inverted based on the 10yr-1mo differential:
Source: U.S. Department of Treasury, WingCapital Investments
As discussed in the previous article on why 7-10 yr Treasury ETF (IEF) will likely outperform on a risk-adjusted basis, it is widely expected that the Fed has embarked on a new rate cut cycle, which will lead to the bull steepening of the yield curve like between 2007-2008:
Source: U.S. Department of Treasury, WingCapital Investments
During that period, the 3-7yr Treasury ETF (NASDAQ:IEI) likewise proved to be a strong performer just behind IEF and long-end ETF (TLT) with a double-digit total return:
Source: WingCapital Investments
U.S. Is Now Following Germany's Footsteps
The decisive break under 1% in 10-year Treasury yield is highly significant, if we consider what followed after German bunds similarly pierced through 1% more than 5 years ago. To be specific, after breaking through the crucial support, German 10-year yields continued to fall off the cliff to just above zero before finally rebounding in early 2015:
Source: U.S. Department of Treasury, WingCapital Investments
Thereafter, any bounces were capped under 1% in German yields, as a new trading range between 0-1% was in effect until zero ultimately gave way as well. While we are not ready to forecast negative rates in the U.S. just yet, 0% is most likely the next stop for short and intermediate-end Treasury yields in light of a worsening Covid-19 outbreak domestically as well as a crumbling oil market.
OPEC Debacle: Adding Fuel To Fire
Meanwhile, a perfect storm may have been created in crude oil prices (USO), which had already been free-falling to $40 per barrel on crumbling demand due to the virus outbreak. To make things worse, OPEC's inability to agree on production cuts, followed by Saudi Arabia's declaration of an "oil war" over the weekend, has opened the door for oil to collapse back towards 2016 lows of under $30. To wit from Bloomberg:
Saudi Arabia kick started an all-out oil war on Saturday, slashing official pricing for its crude and making the deepest cuts in at least 20 years on its main grades, in an effort to push as many barrels into the market as possible.
As we write, crude oil futures opened Sunday evening with a 30% crash to just above $30. The implication is that declining energy prices will add to deflationary pressure on the U.S. economy like in 2015:
Source: U.S. Bureau of Labor Statistics, U.S. Department of Treasury, WingCapital Investments
As such, President Trump may very well get his wish of lower interest rates given Fed having little choice but to react. Indeed, the market is already pricing in a 75bp cut according to CNBC:
Friday’s stock market rout and a fresh record low in government bond yields pushed traders to assign a 65% chance of a 75 basis point cut by the March 17-18 Federal Open Market Committee meeting, according to the CME’s FedWatch tracker.
Hence, it appears inevitable that U.S. bonds yields are headed for similar trajectory as Europe, as Treasuries are scooped up while they remain positively yielding. Looking at the dividend and SEC yields of the major Treasury ETFs, an interesting observation is that they are all within a narrow range between 1-2% regardless of the tenor:
| Treasury ETFs Yield Comparison | SHV | SHY | IEI | IEF | TLT |
| Tenor | 0-1 Yr | 1-3 Yr | 3-7 Yr | 7-10 Yr | 20-30 Yr |
| Dividend Yield TTM | 2.08% | 2.03% | 1.86% | 1.80% | 1.81% |
| 30-Day SEC Yield | 1.41% | 1.14% | 1.09% | 1.20% | 1.67% |
As of 3/6/2020
With 10-year yields gapping down to 50bps over the weekend, we reckon dividend yields will become increasingly less relevant in the Treasury ETFs as they converge towards zero. To conclude, similar to our thesis on the 7-10yr Treasury ETF (IEF), we are likewise bullish on the 3-7yr Treasury ETF (IEI) as we anticipate the intermediate-end of the yield curve to outperform on a risk-adjusted basis during the course of Fed's rate cut cycle.
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