Basic thesis: We are in the “process” of changing the deep-rooted trend for long-term interest rates (the U.S. 10-year yield). It’s a process that has been going on for more than a year and a half now…and this shift could (should?) continue now that the supply/demand equation for the Treasury market is changing in a significant way.
It’s funny how people seem to forget that the yield on the U.S. 10-year Treasury note bottomed more than 20 months ago (at the beginning of July 2016)! The rise it has seen since then has come in two phases…and we believe the third phase will begin if/when the 10yr note moves above 3% in a “meaningful” way.
The first phase took place in the second half of 2016…when the yield jumped from 1.35% to 2.6% over the next six months (an increase of a whopping 91%.) This spike higher began with a very nice long-term “double-bottom” from 2012 & 2016. Not only did the yield on the 10yr note almost double, but it also moved well above its multi-year trend-line from the 2010 highs (just after the credit crisis)…..When rates came back down in the first half of 2017, the yield on the 10yr never broke back below that 6-year trend-line!!! So that was the first signal that the trend for long-term interest rates was beginning to shift.
The second phase took place when long-term rates spiked higher once again (from September through January)…when yields jumped from 2.04% to 2.95% (a 45% rise). This time, the move took yields above their multi-decade trend line going all the way back to the mid 1980s!!!! So this was another indication that the long-term trend for interest rates is in the process of changing. (Yes, they’re still low by historical standards, but they’re still 115% above where they were in the summer of 2016!)
The next key resistance level is the 3% level. This is not just a “round number”…it’s also the “double-top” highs from 2013 and early 2014. So any meaningful break above that level would give it a key “higher-high”…and add to the evidence that the long-term trend for interest rates is shifting from an downward trajectory to an upward one.
This “third phase” might not come immediately (9 months passed between phases 1 & 2). However there’s no question that the 10yr yield is very close that key 3% level, so it’s something we’ll NEED to keep a close eye on going forward.
The thing is, this move in the yield on the 10yr note up to near its next key resistance level…is coming at a time when the supply/demand equation for Treasuries in the midst of a dramatic change. On the demand side, the Fed is moving from being a massive (and “price insensitive“) buyer with their multiple QE programs…to one where they are buying fewer bonds…and this level of buying will shrink dramatically as we move through the year. In fact, the total that will be allowed to “roll-off” the Fed’s balance sheet will go from $30 billion in 2017…to $420 billion in 2018!!!……..On the supply side, the Treasury is going to more than double its issuance this year (to over $1 trillion)…to pay for the the new fiscal programs (and it will be a lot more if they pass an infrastructure program).
We keep hearing how only two things will lead interest rates to keep climbing. One would be a pick-up in growth without inflation (which would be good)…and the other is one where we do see inflation raise its ugly head which would be bad)…..They never talk about the shift in the supply/demand equation. Given how much of an important role this supply/demand equation played in the decline in rates over the past decade (to levels that were “abnormally” low), it’s surprising that most pundits don’t think it will play a key role in the other direction now……Let’s face it, we’ve seen a decent amount of weaker-than-expected data recently…and yet the yield on the 10yr is still near it’s multi-year highs!
(Actually, it’s not all that surprising that most pundits don’t talk about the supply/demand equation. These issues weren’t in the text books that economists had when they got their graduate degrees…and they never spent any time on a trading desk. So they just go back to their theoretical rules…which don’t work as well as they use to in today’s markets.)
Anyway, we DO have to admit there is no guarantee that long-term interest rates will indeed move above 3% immediately. Again, this is a “process”…and it could take quite a long time to play-out. (We cannot rule-out “flight to quality/safety” moves…but they won’t be bullish for other markets.) In other words, this long-term “shift” won’t take place in a straight line…and thus we might not have to worry about it in the coming days and weeks. However there is no question in our minds that the action of the past 20 months is telling us this long-term trend for interest rates is changing…and this is something investors have to provide for over the coming months and years.
Many people say they’re “long term investors”. That’s great…and it’s a smart way to invest. However, going forward, this means that they should understand that a change in the long-term trend for interest rates seems to be playing-out right now. Therefore they NEED to at least consider this probable change…when mapping-out their “long-term” investment strategies.