My Case for Treasury Yields

My base case is that Treasury yields will rise over the next few months as the economy continues to heal. I don't have a particular forecast for where exactly the 10-year Treasury will go, but somewhere between 0.90% and 1.10% is very reasonable. Here are the three key pillars of this view, including some news this week that I think bolsters my case. Companies will hire more aggressively than after 2008 This week the National Federation of Independent Businesses released their monthly small business confidence survey. Despite smaller firms generally being hit harder by the Covid recession than larger ones, the survey was quite positive. The overall optimism score of 104 is right in line with the 2019 average of 103. More importantly for interest rates, the hiring plans segment was quite strong, registering the highest reading since 2018. This comes on the heels of the ISM Services survey from last week, which also showed positive net hiring plans. Although that read was only 51.8, still below the 55 or so level from 2018-2019, that it was positive is notable. In the prior recession, the time between the hiring index's first negative read to its subsequent positive read was nearly three years. This time it was only six months. The small business hiring rebound is even more stark. After the previous recession, it took until 2014 for the NFIB hiring index to get back to its average level from 2006 and until 2017 before it was consistently that high. I believe firms are hiring more aggressively in part because they are just more optimistic now compared to 2008. But I also think firms are remembering how hard it was to hire people in 2018-2019. They are assuming that the labor market will eventually get that tight again, and they don't want to get caught flat footed. If that's true, it would represent a virtuous cycle: expectations for a tight labor market become self-fulfilling. More fiscal stimulus is ultimately likely, but may be in 2021 I have very little expectations for the current negotiations over fiscal stimulus. However, the politics are almost certainly going to look quite different come January. If the polls are to be believed, we'll have a different party in the White House and perhaps a change in control of the Senate. It may also be that without an election hanging over everyone's heads, the negotiating position of both sides might change. Regardless of your political views on whether more government spending is a good long-term idea, it will definitely boost aggregate demand in the short-term. A hypothetical second round of stimulus will have a bigger effect on interest rates than the first. In April, the personal savings rate soared to 33.6%, in part because so many people choose to save the stimulus payments and/or unemployment checks they were getting. In August, that same figure was down to 14.1%, and I'd bet that figure keeps falling toward a more typical 6%-8% area. Hence any new stimulus will flow more immediately into current demand. On the flip side, less savings means less idle money sitting at banks that winds up getting invested in the bond market. So we'll have more demand for good and less demand for whatever additional Treasury bonds get sold to fund the stimulus. Some amount of inflation will be priced in Currently markets aren't too optimistic about the Federal Reserve's new average inflation targeting regime. The 5-year TIPS yield implies that the Consumer Price Index will average 1.5% over the next five years, which is no higher than before the Fed announced the change in policy. To be sure, there is no current evidence of inflation pressure building. Some analysts have claimed there was evidence of a supply crunch in the fact that goods inflation was rising faster than services inflation within the CPI. In general, I'd tell the reader to be wary of this kind of disaggregation. It usually boils down to if you remove everything where prices aren't going up, prices are going up! No kidding. Anyway, this week's CPI report should put that trope to bed, as most of these key goods sector prices slowed (or fell), including clothing, sporting goods and furniture. However as unemployment continues to fall and wages pressure starts to build, markets will come around to the long-term power of the Fed's new approach. All it will take for yields in the 10-30 year zone to rise is the prospect of higher inflation way down the road. I argue this is a recipe for longer-term rates to rise while short-term rates remain about the same. Trade ideas I don't think interest rates are likely to soar higher in the short-term. There remains robust global demand for bonds, and all the big central banks will still be stuck at zero. A really large sell-off in U.S. bonds would probably be gobbled up by yield hungry investors. However longer-term yields rising 20-40bps is certainly possible, and I'd argue much more likely than yields falling meaningfully. That's not a great set-up for an outright short position in bonds. If the 10-year only rises 20bps and it takes 3-4 months, the net price decline will be small. However a long position in 5-year bonds paired with a short position in 30-year bonds is a great trade. To do it in a duration-neutral way, you want to be long four parts for every one part of your 30-year short. The trade is approximately carry neutral, so time is on your side. We also like being long corporate bonds right now. The scenario I'm describing is a great environment for corporates, so spreads should tighten, which will partially or fully offset any price decline from rates rising. If you are a long-only buyer, we like being long corporate bonds in the 5-10 year maturity segment while underweighting (or zero weighting) bonds longer than that.

My Case for Treasury Yields

Here are some trade ideas that include being long corporate bonds right now.

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