Rates for long-dated interest rate vehicles have been edging up, and it’s important to be prepared for an even greater shift in the low-rate environment we’ve been in. The yield on the 10-year Treasury note is approaching the critical 4 percent barrier, which we haven’t seen since 2008. Whether you are a trader, homeowner or consumer, higher interest rates will influence your investments, your consumption and your cost of borrowing.
Higher rates are likely to create greater competition for investor dollars that have been flowing into commodities and equities over the past year. We will have a situation at some point in time where interest rates will affect your portfolio–whether you realize it or not. It pays to be prepared for that scenario, even if macroeconomic trends don’t change dramatically for a few months.
There has been a lot of discussion in the financial press lately about will happen at the long-end of the yield curve, namely 10-year Treasury notes (the main instrument on which mortgages are priced) and 30-year Treasury bonds. Mortgage rates have moved back above 5 percent. Part of the reason is that the Federal Reserve has decided to remove a key economic stimulus program, the buying of mortgage-backed securities. That program has helped lend support to the market over the past year, and has kept interest rates artificially low for a prolonged period at the long end of the yield curve.
This month, the yield on the 10-year Treasury note reached 3.90, the highest level in nine months (the 10-year note yield reached 3.94 percent in June 2009). The market looks poised to head even higher in coming weeks or months. If the market takes out that June peak, it would mark the highest level since October 2008, when the financial market crisis took hold. The 30-year bond yield has reached 4.75 percent.
This has resulted in a sell-off in Treasury futures, whose price moves inversely to yield. Shorter-dated interest rate instruments have been more insulated, as the Federal Reserve has vowed to keep the key short-term interest rate under its control extraordinarily low for an extended period. That will eventually end, too.
The market has embraced the flow of cheap money that has been flowing into the economy through fiscal and monetary policies. Since late March of last year, the S&P 500 has had an incredible run—probably one of the best in many years. In 2009, the S&P ended the year up more than 26 percent. The equity market might have more trouble generating capital in the months ahead if interest rates continue to move higher. Given the shocks they experienced over the past two years, investors might feel more comfortable in what they perceive as safer instruments with more defined returns—such as Treasuries—rather than speculative investments such as commodities or equities.
As interest rates go higher, U.S. dollar-denominated interest rate products will benefit. Higher rates are likely to cause the dollar to strengthen, and as commodities are priced in U.S. dollars, that wouldn’t be favorable for price trends in many commodity markets. If the current economic environment stagnates and the problems in the labor market keep the Fed from raising rates at the short-end of the curve, then we may see increases in commodity prices (including $100 oil in 2010). But I don’t think the era of artificially low rates can last much longer.
The Fed can control the short end of the yield curve, but not the long end—market forces do. Everyone right now is focused on the eurozone, but there are other factors in the U.S. to consider that market participants are already anticipating.
Clearly, there is buying going on in the equity market and other risk-play assets, but it’s giving some professionals an uncomfortable feeling at these levels. Assets that have benefited from cheap-money stimulus measures over the past year will likely reverse once monetary policy changes.
I feel it’s time to start focusing on the downside in commodities and equities more so than trying to get in on the last gasp before market tops. The market is the final determiner of how things will play out, but a strategy to protect yourself from some downward moves seems prudent in my opinion. Buying puts on the S&P or crude oil with defined risk on major moves higher seems like a strategy worth considering. You might want to consider buying 75 puts in June crude oil, for example, or 1,000 puts in the September S&P. I think it’s time to start focusing on bearish elements in the marketplace, and I think yields will be a dominating factor. It’s just a matter of time before they head up.
Feel free to contact me with any questions you might have about the markets, and to develop trading strategies appropriate to your unique situation.
Adam Klopfenstein is a Senior Market Strategist and can be reached at 800-266-0551 or via email at aklopfenstein@lind-waldock.com.
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