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How High Can Treasury Yields Go?

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PETER TCHIR TALKS BONDS
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We finally broke through the 10-year Treasury yield (INDEXNYSEGIS:AXTEN) levels set 10 days ago. On Wednesday, we tested those levels twice and failed, but as of Thursday, we are cleanly through them.

10-year Treasury Intraday Yields


For a while, it looked like we wouldn’t breach those levels, but now that we have gone through 2.94%, the big question is, how high can we go, and how quickly can we get there?

10-Year Treasury Intraday Yields


The easy question to answer is on timing -- quickly. Between algos driving much of the market, funds looking for a trend to ride, convexity hedging, and any remaining stop losses, we think we will see 3% quickly.

Our 3.1% target seems to be a likely level to spike to though on our simplistic chart, though 3.2% seems like a better resistance level. We put in the 3.75% line to really get the bears excited, but our call remains a spike through 3% to a little over 3.1%, where we will look to buy.

The spike above 3% will be aided by the media.

Just as “S&P (INDEXSP:.INX) 1,500” or “Dow (INDEXDJX:.DJI) 10,000” or even “IG200” headlines can attract more attention than they deserve, the “10-year Breaks 3%” and “Yields hit Multi-Year Highs” headlines will be in abundance. Those headlines can and do move markets.

It will take great fortitude to buy with those headlines staring you in the face. RIAs and RRs will be fielding calls from investors concerned about rising rates.

It an be argued that they have been fielding those calls for months now, but the volume and intensity and level of concern will increase further. The easy answer is to sell, but it's probably not the right one.

That is how we see the 10-year Treasury playing out.


How Vicious Will the Snapback Rally Be?


It might be too premature to discuss the rally since we haven’t even gotten the sell-off yet. It might be just plain stupid to think about timing a bounce, but there are reasons to think that we can see a big rally at some point.

Again we aren’t expecting the move just yet, but look at these charts:

10-year Treasury RSI Since January 2012


We are hitting conditions where yields look overbought (meaning Treasuries are oversold), which has been a consistent little indicator.

Every time we get to overbought, we get a rebound where yields drop. The size and duration of the rallies has been decreasing, which is a bit of a concern, but if we are right that we get a spike to 3.1% in a very short time, the overbought conditions will be extreme. Any sort of simple mean reversion back to any of the moving averages would also imply a pretty extreme move tighter.

As more people pile into the short the 10-year and the hype grows and “mortgage convexity hedging” becomes a dinner party conversation topic, the conditions will be set up for a massive rally.

10-year versus 30-year Treasury Spread


The curve has flattened an incredible amount. While we had argued that curves had been too steep for a long time, it now seems that at least 10s 30s might be getting too flat. We are almost at levels we only saw during the midst of the crisis. With the Fed still seemingly on hold at the front end of the curve, we think you need to get more of a sell-off there, or a rebound in the 10-year point.
 

Bear Flattener


The biggest risk to the market as a whole remains the bear flattener trade. That is when all rates are rising but short-term rates are rising faster.

That is bad because:

1. Longer-maturity assets lose value.
2. The cost to fund those positions goes up.

That is always a deadly combination, especially when coupled with leverage. Our good friends in the leveraged loan market have been relying on leverage. CLOs, a key driver, are all about leverage. NOTHING will be worse for that market than if LIBOR starts to build in rate hikes. Remember, the loans have LIBOR floors so they will NOT benefit from an increase in LIBOR. But the senior obligations will see their costs increase in lock step with LIBOR. That is dangerous.

It is safe to assume that some hedge funds own investment grade bonds, likely on a spread basis, but if we are correct and yield-selling forces spreads to go wider, they will be hit particularly hard by this combination. You don’t make 10% annual returns on investment grade spread bets without a lot of leverage (10 times?).

A “Bizarre” Move in the Curves




In a market that remains distorted by the Fed, we see a slightly strange “kinked” move where the brunt of the yield increase has been in the belly of the curve (5 to 10 years). The long bond has been supported by a variety of factors, but mostly that neither inflation nor growth really justify yields that are so high. The front end benefits from the commitment of the Fed to hold rates at zero. The Fed has mentioned tapering, or reducing QE, but has not once backed off the low rate promise.

It is the front end that bears extra scrutiny. Is this the part that someone like Summers will attack? It is unprecedented to have Fed Funds below inflation for so long -- will someone else will decide it is unprecedented because it is a bad idea?

September 2014 Eurodollar Futures


The market is pricing in the highest chance of a rate hike since Hilsenrath took office (oops, I mean leaked a statement about how the Fed won’t hike).

Short-term rates are too low. Any other Fed would likely have raised them by now because they are 1% below where inflation is running, creating negative real yields, and because enough signs of growth are appearing. This Fed has pledged low rates for a long time, but this Fed is ending. It is ending January 31 and evidence mounts that Obama isn’t happy with all their policies, so maybe they will act preemptively? 

We still like being short Eurodollar futures. It isn’t something we write about every day since normally it is a pretty dull market, but look for a potential capitulation here.

It is Eurodollar futures that will signal whether the market believes the Fed will stick to its ZIRP pledge or not. It is here that we will see the signs of a more painful bear flattener hitting the entire market.

2-year Treasury versus 10-year Treasury


While the long end of the curve has been flattening, the front end has been steepening. The 2-year has been relatively anchored. That is what is causing this extreme steepness.

Something has to give. In all likelihood it will be the 10-year rebounding because yields above 3% are hard to support with the 2-year at 0.49%, Fed Funds at 0%, GDP growth at 2%, and inflation less than 1.5%.

Our view is that we will see a real rebound in the 10-year prices after we get a good capitulation. The major stock averages like the S&P 500 and Dow should get a little weaker on the back of that, particularly dividend and “cash flow” stocks -- and today's weak NFP report supports the idea of stocks pulling back, though it also means that our 3.1% 10-Year target area won't be hit immediately.

Ultimatley though, if we see more evidence that rate hikes are potentially on the table, then look out below for all domestic risk assets.

This article is a special, complimentary edition of Peter Tchir's Fixed Income Report. Click here to take a FREE two-week trial and receive Peter's special report Fixed Income ETFs: $250 Billion Reasons To Get In.
POSITION:  No positions in stocks mentioned.

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