With the U.S. 10-Year Treasury poised at a key technical level, just two days in front of the May ’14 employment report which is due out Friday morning at 7:30 AM central, we continue to be fascinated by the Treasury market’s action.
In 2014, we’ve essentially seen a sharp 10-year Treasury rally that has taken the 10-year yield from 3% as of 12/31/13, to as low as 2.41% last week at this time.
Just since last Wednesday, the 10-year yield has jumped from 2.41% to 2.60%.
What is puzzling to me is that the Treasury complex rallied across the curve after stronger March ’14 and April ’14 employment reports, particularly April’s report, when net new jobs created totaled 288,000 and when in fact consensus was looking for something along the lines of 225,000.
However, the biggest conundrum is the sudden acceleration in inflation over the last few months, which should have sent Treasuries reeling from the get-go.
Bespoke Investment Research, which in our opinion does some of the best macro, top-down analysis across the stock and bond sectors, published this table as part of their weekly summary that is sent to clients every Friday night.
Note the rapid jump in the “PCE” and the “Core PCE”. While the absolute level remains benign, note the “rate of change” in all the inflation indicators over the last two months.
I guarantee you, this inflation data alone should start to worry the Treasury market if it signals more than a temporary blip.
If the Core PCE starts to move over 2%, which is the Fed’s supposed “inflation-comfort” target, then Treasuries should start to reflect that tension.
Remember, part of a bond’s return is its “real” or inflation-adjust return. If, according to the Bespoke inflation data, the core PCE is 1.42% annually, then the 10-year Treasury’s current “real return” after inflation is 2.60% – 1.42% or 1.18%. Over long time frames though, Treasuries should yield a 2% real return over inflation. To get to 2% the 10-year Treasury yield should trade at 3.42% which would get it to parity in terms of long-run, real returns.
Like a lot of investors today, we have been underweight duration and interest rate risk for most of 2014. We are long the ProShares Short 20+ Year Treasury (NYSE:TBF) in client accounts, which might just be starting to pay off.
Part of the duration puzzle has been the extreme negative sentiment in the Treasury market as this article details. Managers have been short their duration benchmarks for the past 4-5 years, and have suffered greatly for it, just like in 2006 and 2007.
The three key 10-year yield levels we are watching:
1.) 2.60% (and the 10-year is trading there as of yesterday);
2.) If the 10-year yield rises above 2.60%, then 2.82% – 2.83%;
3.) Through those levels and the 10-year is likely to return to the 3% area;
We have room and time to adjust client portfolios accordingly. Friday’s May ’14 jobs report might result in further adjustments.
Technically, the 10-year yield may have an issue trading through 2.63% and 2.72% as these are the respective 50 and 200 day moving “yield” averages, on the chart.