Don't Get Trampled by Rising Yields

By ETFguide.com  NOV 12, 2013 3:32 PM

What rising yields mean, and how to hedge against further increases in interest rates.

 


If you haven’t noticed, the bull market cycle in bonds is starting to show major cracks. Some yields have risen over 50% thus far in 2013! Is the 30-year bull market in bonds finally breaking?

Never mind the fact that the recent rising yield environment shows the Fed’s Quantitative Easing (QE) program is failing. And never mind that Ben Bernanke himself admitted he too was also “perplexed” by this summer’s fast rising yield environment.

If yields continue to rise, eventually the Fed will start to be a cost center as opposed to an income stream for the Treasury. This will no doubt raise even more questions as to the sustainability of the Fed's programs.  Yields may now be rising for good, which will trump any new band-aid the Federal Reserve tries to throw at the problem.

In reality, the Fed is backed into a corner. And like a mouse that's invested the public's capital, it's stuck in a room with the elephant that is the world's private capital.

Eventually, the market always wins and the Fed is just one other player in the $80+ trillion global bond market.

Rising Yields – What It Means

Who are the winners in a rising yield environment? Almost no asset classes win because money is shifted back into savings and income-generating endeavors, and away from riskier more capital-appreciating mediums.  Debt is paid down instead of issued as the available capital contracts.

The rising cost of debt makes it less and less attractive as a financing vehicle as it sucks more profits from companies and their discount rates rise.  Multiples eventually will contract in such an environment as stock returns become less favorable when compared to other available investments.

Investors will save more and get better returns on their checking and savings accounts as they shift money back to now neglected money market, CD, and cash accounts.

Investors should be aware of the coming rising yield environment paying attention to a few of the signs we are watching for a confirmation of the long term change in trend in the bond market.

The short and intermediate terms have confirmed a trend change, and once the longer term confirms, investors should be fully prepared for yields much higher than today’s levels.

Rising Yields – What to Watch

In our August ETF Profit Strategy Newsletter I summarized the recent explosion in bond yields as we warned of a steepening yield curve which has much larger and even more ominous implications than just rising yields alone.

A rising yield curve means that interest rates farther out in time are appreciating faster than interest rates with shorter durations.  The chart below shows the yield curve updated through this week and displays the history of the yield curve and why we see it as a major warning sign that recent bond yield increases may not be near as bullish as many suggest.

A rising yield curve has been associated with every major recession of the past 25 years (’90,’00, and ’08).
 


Rising Yields - How to Protect

In May we were warning that a rising yield environment was around the corner as our Technical Forecast readers were provided analysis, charts, and trade alerts like “IEF remains the safer Treasury bond fund”, “continue to switch bonds into shorter durations”, and “shorter term bonds such as the iShares 1-3 Year Treasury Bond (NYSEARCA:SHY) or the SPDR Barclays 1-3 Month T Bill (NYSEARCA:BIL) remain the safer place for your bond money”.

Since then, the iShares 20+ Year Treasury Bond (NYSEARCA:TLT) has continued to underperform and is fast approaching a level that will signal its longest term up trend is indeed over.
 
Those who shifted their Treasury exposure in the meantime have gained over 9%.

The chart below shows this outperformance of the shorter duration Treasuries since that time.  As the bond market bear starts to really growl, these shorter duration Treasuries should continue to outperform their longer term counterparts.



As suggested in July in my article "Is a Rising Yield Curve Bullish," we also like buying the iPath US Treasury Steepener (NYESARCA:STPP) to hedge from further rises in interest rates and the yield curve. STPP should gain in price as interest rates also continue to rise.

For more aggressive traders, a good entry point for the ProShares UltraShort 20+ Year Treasury (NYSEARCA:TBT) is likely around the corner and will take levered advantage of a Treasury bond trend that continues downward.  But given the inherent leverage in some of these ETFs, timing is everything, so waiting for the right entry opportunity is crucial.

The Treasury bull is on its last legs and investors need to start prepping for an environment of rising yields as we wait for our next high probability trading opportunity in TBT and the Treasury market. 

Editor's note: This story by Chad Karnes originally appeared on ETFguide.com.

To read more from ETFguide, see:

Predicting the Bursting of a Market Bubble

Gold: A Sucker's Paradise

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