Everyone is either going wild over zero-days-to-expiration options -- 0DTE -- or fixated on the 2-Year yields.
And this brings up about 100 iterations of the following question: Shouldn't I just put my money into 2-Year Treasuries? They are yielding 5%, after all?
Where to invest on the yield curve is always on my mind, but suddenly everyone seems to be talking about the 2-Year. Not just bond "geeks," but mom and pop investors. And they're not just about where on the yield curve, but as part of every asset allocation conversation. Bob Pisani and I spoke last night for this CNBC piece on "tech and quality stocks" and he also mentioned he was inundated with questions, from unlikely corners, about the investment merits of the 2-Year Treasury.
Several questions need to be answered to determine how much weighting you should have in the 2-year Treasury relative to normal:
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What is the right mix between stocks and bonds?
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Within bonds, what is the right mix between credit risk and rate risk?
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Within rate risk, where on the curve do you want to be?
I feel compelled to discuss this, because on major thesis making its way around market is that:
Everyone will sell equities to buy the 2-Year Treasury. I feel compelled to fight against that.
Looking Back to 0.3%
The best time to buy the 2-Year was at 0.3%. This is backward looking, but worth thinking about. The 2-Year, broke below 0.3% in March 2020. The first time it traded above 0.3% was at the end of September 2021. The 0.25% bond, issued Sept. 30. 2021 is trading at 97.25% of par right now. Not a particularly good investment in its own right, but remember the following: The 2% bond that was the on-the-run long bond then, is trading at 67.5% of par -- a loss, orders of magnitude larger than buying the 2-Year. Also, the Nasdaq 100 is "only" down 21% since then, and the ARK fund (ARKK) , which was then a "must have" for any investor is down almost 70% since then.
When people were chasing yield and return any way they could, no one wanted the "measly" yields provided by the 2-Year. TINA (There Is No Alternative) and FOMO (Fear Of Missing Out) ruled the day. The Nasdaq 100 peaked in December 2021 and ARKK peaked in March 2021.
The "right" trade, for the buy-and-hold type of investors (anyone with a one- to two-year time horizon) would have been to buy the 2-Year Treasury when it was yielding next to nothing, not because it provided a "solid" return, but because it had far less downside (and upside) than other choices.
Chasing What?
Would you be buying the 2-Year only to chase stocks up 7%? One path seems so obvious to me, that I feel I need to mention it: Buy the 5% yield today. Then watch stocks rise 7% in three months. Then, sell bonds, having earned about 1.25% (a quarter of carry), while missing a 7% rally in stocks.Yes, I understand that people are buying the 2-Year because they are afraid stocks will fall further. But none of us "know," which way stocks will go next. What I feel comfortable "predicting" is many of the people buying bonds instead of stocks today, will be "forced" to buy stocks higher, if they move higher and in many cases will be too afraid to buy stocks lower if that happens.
I've been bearish stocks off and on for the past two years. I have no trouble trading stocks, or bonds (in fact that is what in theory I'm paid to think about). But if you asked me "What will provide the greater return in two years, the 10% from holding the Treasury or a stock investment?" I'd have to go with stocks.
Opportunity Knocks
I'm going back to the three questions I posited at the beginning of this column.
What is the right mix between stocks and bonds?
I like risk assets here (see Sunday's TGFF T-Report). I think there is upside for stocks. Am I concerned that people are selling stocks to buy bonds? Sure, but will that help any squeeze? Definitely. I'd be overweight risky assets (more stocks than credit).
Within bonds, what is the right mix between credit risk and rate risk?
I'm comfortable with credit risk. I'd be overweight credit risk (particularly investment-grade corporate and senior tranches of collateralized loan obligation, or CLO, risk) relative to Treasuries. If you lean toward high yield, leveraged loans, commercial mortgage-backed securities, junior tranches of CLOs, then I'd count that against my equity allocation (as there is a risky element that will correlate well to equities).
So that leaves me with a smaller than normal weighting in rate risk.
Within rate risk, where on the curve do you want to be?
Now this is a trickier question and I could easily see over-allocating, even significantly over-allocating to the 2-year. For the moment, let's move to the 3-year, because there are 3, 7 and 10 year on the run treasuries.
Today, the 3-year yields 4.7% (not as "fun" as 5% but a bit more duration). The 7-year is at 4.2% and the 10-year is at 4%.
The 7-Year bond, three years forward is at 3.6%.
So, if you buy the 3-Year bond today, the 7-Year bond, in three years, when this 3-Year matures would need to be 3.6% to match the total return of just investing in the 10-Year bond today (wow, when I write it, is seems way more complicated than it really is).
Buy a 3-Year bond today. In three years, re-invest those proceeds in a 7-Year bond instead of buying a 10-Year bond today.
Do you think the 7-Year bond, in three years, will be lower than today's 7-Year bond by about 0.6%?
Would a longer term, "stable" rate for Fed Funds be around 3% or so? If the Fed gets inflation under control, why not? If inflation runs at 2% at some point in the next few years, then a 1% real rate, gets us to 3% without any sort of term premium.
Right now, I actually like, even with the inversion of 110 basis points, between 2s and 10s, I think I prefer the duration.
Yes, a flatter yield curve would be nicer. I do think the curves should be less inverted.
I'd run a shorter duration portfolio than normal, but I would not be 100% into the 2-year. With so many wildcards out there, many of them Geopolitical (see our Geopolitical Summit West Summary) I'm not completely afraid of owning some duration.
Funding Cost and the Great Financial Crisis
I will never, ever, ever forget that in the early days of the financial crisis, a bunch of attempts were made by policy makers to make it easier and cheaper to fund mortgage backed bonds (all the stuff of "The Big Short" fame). Every announcement led to a pop in asset prices that was quickly faded as it doesn't matter if I'm saving 2% per annum on funding on a position that is leveraged and is dropping 1% a day.
Today's argument is a bit of a corollary to that, but funding and yields and carry aren't the be all and end all. Returns drive everything.
Just like lower yields couldn't avert the mortgage-backed security mess, I don't think higher yields can completely stop markets (I will be bearish risk again, but I'm not right now, and fear of people selling stocks to buy the 2-Year is not high on my list of bearish worries).
Bottom Line
The 2-Year Treasury above 5% makes for some great headlines and is an easy one for the nightly news to glom on to. There is an appeal to 5%, but it is a bearish trade, and I'm not that bearish right now.
Does it impact how I position my portfolio? Yes, but only at the margins. It is not a panacea. Maybe it will turn out to be the "right" trade, but this is setting all of my contrarian alarm bells off, and is another reason I'm comfortable being long risk here, hoping for another leg higher as people get forced into the market. And yes, I might be buying the 2-Year at 4.75% in a week with stocks down 5% and my tail between my legs....
