Bonds Are In a Bit of a Deadlock

 | Jan 12, 2018 | 3:00 PM EST
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The 2-year U.S. Treasury note crossed the 2% threshold today for the first time since September 30, 2008, which was in the midst of its plummet after the Lehman Brothers blow-up. The catalyst for today's move was the stronger-than-expected reading in the CPI, with Labor Department data showing a rolling one-year average of 1.8 percentage points in the December CPI vs. market expectations for a 1.7% rate. While some might herald this as a long-delayed return to normalcy for the U.S. bond market, the stubborn refusal of the back end of the curve to climb is producing a scenario that is contractionary for financial intermediaries.

I have written about the spread between the 2-year and 10-year U.S. Treasuries often in my Real Money column, and it just keeps dwindling. The 2-10 spread sits at 55 basis points as I write this, versus a reading of 80 basis points three months ago and 99 basis points six months ago.

So, the bond markets are in a bit a deadlock, and something's gotta give. Some bond bears point to ridiculous conspiracy theories like the position mooted on Bloomberg earlier this week that:

Senior government officials in Beijing reviewing the nation's foreign-exchange holdings have recommended slowing or halting purchases of U.S. Treasuries, according to people familiar with the matter.

As the kids on the playground would say, "Is that all you got?" I'm so sick of these garbage stories in the mainstream media based on non-attributed sources that I can't even read them anymore. When there is an actual change in the data reported by Treasury I will worry, but until then I will ignore the fake news. I choose to concentrate on the fact that China increased its holdings of U.S. Treasuries by $131 billion dollars in the first 10 months of 2017.

But ultimately the 2-10 spread is a measure of the expected pace of economic growth. The 2-year yield is telling us that the market is worried about an increase in the rate of current period growth (which economic theory tells us should be inflationary), while the 10-year yield is telling us that the market's perception of the pace of longer-term systemic growth is still not terribly sanguine.

So, who's right? If the bears on the 2-year are correct, that's good for stocks, as it implies that price pressures exist in this economy and that companies will be able to pass those costs through to customers. Inflation is good for stocks in the short-term. If you don't believe that inflation helps stocks, check a 1-month chart of Exxon (XOM) , Chevron (CVX) , or some of the smaller E&Ps favored by my firm, Portfolio Guru, LLC, like Sanchez Energy (SN) , Denbury Resources (DNR) and Gastar Exploration (GST) .

If the bears on the 10-year are right, however, that's a negative for stocks, especially those that pay a relatively high-yield such as REITs and utilities. Unlike (AMZN) or Facebook (FB) , those stocks compete with Treasuries for income investors' dollars, and as the benchmark increases those stocks become less attractive.

My guess is that the bears on the 2-year are correct. Higher energy prices are beginning to hit the consumer, and that impact will increase dramatically as the back end of the energy curve stiffens. You would have to go out to March 2019 to lock in a barrel of oil for less than $60 in today's market, and that will be felt by consumers at the pump.

My other guess is that the bears on the 10-year are incorrect. I don't think China is going to halt purchases of U.S. bonds, and I don't believe that the Tax Cuts and Jobs Act is enough to change the true path (economists/geeks call this an exogenous shift) of the U.S economy's growth trajectory.

Watch for continued pressure on the 2-10 spread. If there is any evidence at any time that the U.S. Treasury yield curve is going to invert -- that has traditionally been the mother of all sell signals for stocks. So keep an eye on rates even if you only own stocks.

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