Overstimulated: Government Spending and Its Impact on Bonds
by Brandon Chapman, CMT
As the Obama administration settles in, many opaque revelations have emerged regarding possible policy action to handle banks and stimulate the economy. But among the uncertainty is a clear message that this administration and the Fed Chairman intend to spend our way out of the current economic slump. The efficacy of their actions and its eventual economical impact will likely create market indecision. Investors will do well to recognize where trading opportunities generated by these circumstances may arise.
Bonds ReactionAmidst early rhetoric from the Obama administration, Treasury bonds with long-term maturities have failed to provide investors with much of a safe haven from January’s recurring stock sell-offs. In fact, Treasury bonds with 10- and 30-year maturities were met with selling pressure as prices fell and yields moved higher. This reaction is in contrast to the buying that occurred as equities fell at the beginning of January.
InterpretationThere are two factors investors can take away from long-term Treasury rates’ significant move higher.
First, the proposed spending amount will likely cause higher inflation down the road, making investors nervous because of the length of time required for these bonds to mature as well as their extraordinarily low yields. Along with future inflation concerns is the strong chance the U.S. will issue trillions more in debt during the upcoming years. This will likely prompt many foreign governments to diversify away from U.S. debt.
Second, the market sell-off failed to yield the same degree of strain on investors that was so palpable amidst the November swoon. The bullish base that may be building kept major market gauges from testing the 2008 November 20 lows in January.
While it may be unrealistic to see bond yields hit multi-year highs any time soon, it may be reasonable to see rates return to levels during the 2008 October time frame.
Intermarket PerspectiveWhen analyzing any asset class - bonds, stocks, commodities or currencies - it is important to remember that a connection exists between them. With this in mind, watching their interaction may tell you something about where we are in the business cycle and what stock sectors or asset classes should be outperforming or underperforming.
As mentioned, the bonds sell-off that has seen long-term rates rise will help promote strength in equities in the short-run while money moves from one asset class to another. However, a potential sign to look for would be a decline or leveling off in the appreciation of the U.S. dollar. One way to easily track the dollar against a basket of other currencies is the PowerShares DB U.S. Dollar Index Bullish (UUP) - an exchange-traded fund (ETF) that tracks the U.S. dollar index.
As the U.S. dollar runs toward its October and November highs, gold prices are experiencing strong appreciation. Typically one expects to see an inverse relationship between gold and the greenback because of inflation implications. However, gold’s persistence to outperform equities during a recession and a rising dollar represents the demand for hard currency, while also supporting a rise in long-term bond yields, and for equities to continue to work out a bottom in coming months. An easy way to track gold’s movement is through the SPDR Gold Shares ETF (GLD).
Setting UpHistorically, trading bonds has been cumbersome and quite difficult for individual investors. It was virtually impossible for an individual investor to short bonds. The emergence of ETFs has provided investors with the unprecedented ability to diversify across asset classes and easily trade bullish and bearish ends of most markets. However, it is important to consider the efficiency and liquidity of these investment types.
An ETF that allows investors to short bonds is the ProShares UltraShort Lehman 20+ Year Treasury Bond ETF (TBT). This ETF not only tracks the inverse of the 20+ Year U.S. Treasury index but also seeks to make twice the daily movement of it. Figure 1 shows the large breakout on extraordinary volume that occurred at the beginning of January. To reach the low end of its range in October, it would have to move about $10.
Figure 1 - ProShares UltraShort Lehman 20+ Year Treasury Bond ETF (TBT)
ConclusionWhile a lot of uncertainty with financial stocks and what proposed solutions are likely to be put into action still exists, it seems clear that large deficits are in the cards. Because equities retraced nearly 50% from their 2007 highs and the unprecedented buying of long-term Treasuries in November and December of 2008, it appears that current long-term Treasury yields are unsustainable in the long-run. This means lower Treasury prices and higher yields; however, look to other markets to help support any outlook.Brandon Chapman, CMT, works as an investing coach for Investools, a subsidiary of thinkorswim Group, Inc. His weekly commentary can be found on http://www.investools.com/.
As the Obama administration settles in, many opaque revelations have emerged regarding possible policy action to handle banks and stimulate the economy. But among the uncertainty is a clear message that this administration and the Fed Chairman intend to spend our way out of the current economic slump. The efficacy of their actions and its eventual economical impact will likely create market indecision. Investors will do well to recognize where trading opportunities generated by these circumstances may arise.
Bonds ReactionAmidst early rhetoric from the Obama administration, Treasury bonds with long-term maturities have failed to provide investors with much of a safe haven from January’s recurring stock sell-offs. In fact, Treasury bonds with 10- and 30-year maturities were met with selling pressure as prices fell and yields moved higher. This reaction is in contrast to the buying that occurred as equities fell at the beginning of January.
InterpretationThere are two factors investors can take away from long-term Treasury rates’ significant move higher.
First, the proposed spending amount will likely cause higher inflation down the road, making investors nervous because of the length of time required for these bonds to mature as well as their extraordinarily low yields. Along with future inflation concerns is the strong chance the U.S. will issue trillions more in debt during the upcoming years. This will likely prompt many foreign governments to diversify away from U.S. debt.
Second, the market sell-off failed to yield the same degree of strain on investors that was so palpable amidst the November swoon. The bullish base that may be building kept major market gauges from testing the 2008 November 20 lows in January.
While it may be unrealistic to see bond yields hit multi-year highs any time soon, it may be reasonable to see rates return to levels during the 2008 October time frame.
Intermarket PerspectiveWhen analyzing any asset class - bonds, stocks, commodities or currencies - it is important to remember that a connection exists between them. With this in mind, watching their interaction may tell you something about where we are in the business cycle and what stock sectors or asset classes should be outperforming or underperforming.
As mentioned, the bonds sell-off that has seen long-term rates rise will help promote strength in equities in the short-run while money moves from one asset class to another. However, a potential sign to look for would be a decline or leveling off in the appreciation of the U.S. dollar. One way to easily track the dollar against a basket of other currencies is the PowerShares DB U.S. Dollar Index Bullish (UUP) - an exchange-traded fund (ETF) that tracks the U.S. dollar index.
As the U.S. dollar runs toward its October and November highs, gold prices are experiencing strong appreciation. Typically one expects to see an inverse relationship between gold and the greenback because of inflation implications. However, gold’s persistence to outperform equities during a recession and a rising dollar represents the demand for hard currency, while also supporting a rise in long-term bond yields, and for equities to continue to work out a bottom in coming months. An easy way to track gold’s movement is through the SPDR Gold Shares ETF (GLD).
Setting UpHistorically, trading bonds has been cumbersome and quite difficult for individual investors. It was virtually impossible for an individual investor to short bonds. The emergence of ETFs has provided investors with the unprecedented ability to diversify across asset classes and easily trade bullish and bearish ends of most markets. However, it is important to consider the efficiency and liquidity of these investment types.
An ETF that allows investors to short bonds is the ProShares UltraShort Lehman 20+ Year Treasury Bond ETF (TBT). This ETF not only tracks the inverse of the 20+ Year U.S. Treasury index but also seeks to make twice the daily movement of it. Figure 1 shows the large breakout on extraordinary volume that occurred at the beginning of January. To reach the low end of its range in October, it would have to move about $10.
Figure 1 - ProShares UltraShort Lehman 20+ Year Treasury Bond ETF (TBT)
ConclusionWhile a lot of uncertainty with financial stocks and what proposed solutions are likely to be put into action still exists, it seems clear that large deficits are in the cards. Because equities retraced nearly 50% from their 2007 highs and the unprecedented buying of long-term Treasuries in November and December of 2008, it appears that current long-term Treasury yields are unsustainable in the long-run. This means lower Treasury prices and higher yields; however, look to other markets to help support any outlook.Brandon Chapman, CMT, works as an investing coach for Investools, a subsidiary of thinkorswim Group, Inc. His weekly commentary can be found on http://www.investools.com/.
