Bonds, Where To From Here?
In my column yesterday, I compared the earnings yield of the S&P 500 with the 10 year Treasury yield in an effort to determine whether or
not the stocks are still attractive. I concluded that, based on my basic
analysis, they are. In my concluding paragraph, I also mentioned that the 10
year Treasury yield would stabilize below the 4.6 % level over the near term
before moving higher later this year, in my view. Today, I would like to expand
on the reasoning behind my view for bonds.
1) The Yield Curve is currently stretched
A yield curve is a line on a graph that connects the yield values of bonds with
different maturities. But to keep it simple, let’s just compare the yield
on the 2 year Treasury with that of the 10 Year Treasury. Currently, the curve
or spread between these two instruments is about 270 basis points (2.70%). As
you can see on the chart below, the spread is still near its 28 year
highs–reached three weeks ago. The steepness in the curve is due to the fact
that Treasuries with longer maturities, such as the 10 year note, have sold off
and the yields–which are inversely related to price–have gone up. In the
meantime, the 2 year Treasury note has remained relatively stable–since its
value is more dependent on the fed funds rate, which should stay low for quite
some time. However, history has shown that these periods do not last for long
and these instruments revert back to their traditional relationships.
2) Yields have moved ahead of currency valuations
One of the primary determinants of a currency’s value is the spread between
its associated interest rates and those of other currencies. Using the 10 Year
Treasury yield as a simple proxy for US rates, one can see that recent move in
bonds has caused yields to move significantly ahead of the US dollar index,
suggesting that the move is overdone.
