I saw a great question about bond yields from BeamerStockBoy in Discord over the holiday weekend, and am featuring it in today’s blog. I edited the question just a bit.
“I feel as if being bullish on treasury yields is free money this year as we all know interest rates will keep on increasing and yields are highly correlated with interest rates. I want to hear all counter arguments because although the Fed increased 75 basis points instead of 50, treasuries fell after the announcement. My only answer is to stay patient and let the market catch up to the economics but I want to hear all counter arguments”BeamerStockBoy
For starters, I encourage everyone to go read (or re-read) my interest rate primer from last June titled “A Beginner’s Guide to Interest Rates.” It teaches some core concepts that will help you better understand my answer below.
First, interest rates and bond yields are indeed correlated. In fact, they’re synonymous. Bond yields ARE interest rates because they reflect the rate of interest you receive when purchasing a bond. For instance, 10-year Treasury bonds currently yield 3.25%, meaning at current pricing, they pay 3.25% in annual interest.
Second, the specific interest rate that the Federal Reserve controls is the Fed Funds rate. It reflects the cost of capital for banks to borrow money overnight and is thus a short-term interest rate. In last week’s meeting, the Fed lifted the Fed Funds rate by 75 basis points to a range of 1.5%-1.75%. Previously, the rate range was 0.75% to 1%. The Treasury bond (Treasury bill, actually) that most closely tracks it is the 3-month T-bill which currently stands at 1.63%. Note how that’s the exact middle of the target range.
Third, here’s where things get interesting. Per the question above, everyone knows that interest rates will continue to rise. Indeed, the market currently expects the Fed Funds rate to climb to 3.5%-3.75% by the end of the year.
Thus, being bullish on Treasury yields seems like free money. So far so good. But we’re leaving out one essential piece of the puzzle. What’s priced in? Remember, the markets are largely efficient. We’re dealing with a forward-looking, discounting mechanism. The fact that rates are expected to rise has already been baked into bond prices.
To wit, the current Treasury Yield Curve:
Even though the 3-month T-bill is trading at 1.63%, the 2-year is already at 3.17%. In other words, longer-term bonds have already baked in the expected higher rates. Not only that, but the really long-term bonds have also priced in the subsequent rate cuts that will likely occur once the inflation dragon is finally felled. See the 10-year yield only trading at 3.25%, for instance. If the market thought the Fed would boost rates to 4% and keep them there, then long-term yields would be trading higher right now.
Fourth, being bullish on interest rates and profiting from your bias are two different things. There aren’t many retail products that allow for direct bets on interest rates. One of the simplest is to short treasury bond ETFs like IEF or TLT. They’ve certainly been getting clobbered this year. Another is to go long inverse bond ETFs like TBT which rise with yields. But, they’re not free money because future rate hikes may already be priced in. The simplest answer for why treasury yields fell after last week’s Fed announcement is because they ahead already rallied so much ahead of the event.
Bottom line: it is possible for bonds to keep falling and bond yields to keep rising, but at a certain point (and we may already be there) the market will have looked far enough into the future and discounted all future rate hikes into today’s prices.
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