US Treasuries Beckon….Again

In a week filled with negative news reports, economic and otherwise, the S&P500 continued its march to higher highs, ignoring all the speed-bumps along the way. The index rose another 1.0% on light volume. And volatility, while rising slightly, remained at very complacent levels.

Technically, if the S&P was overbought the prior week, it is even more overbought at the close of the most recent week. Investors who are putting new money to work are literally gambling that with prices at all-time highs, not only will prices rise much further (because if they expected prices to rise only a slight amount, then why take the risk?) but also that there will be lots and lots of buyers at those much higher prices willing to give them their cash for those shares. The problem is, history is not on their side.

So as the S&P continues hugging its upper Bollinger band, very much like it did in the late 1990’s and in 2006-2007, the question—which nobody can answer—is simply how long will stock prices continue to stretch higher before the inevitable correction, or worse, takes hold.

US macro news was mixed to weak, as usual, last week. Personal income and spending both beat expectations, but spending rose more than income. How did that happen? Simple—consumers just took on more debt, or drained their savings. This is good for today’s spending, but bad for tomorrow’s economy. PMI services and ISM services both missed expectations. In fact, the ISM figure was the worst in four years. Thankfully, ISM manufacturing beat estimates. But productivity rose less than predicted. And factory orders fell more than expected. The big number of the week was the payrolls report, which beat expectations by only 25,000 (in a country where the total population exceeds 310 million), and Wall Street cheered. Never mind the fact that the unemployment rate ticked up (missing expectations) and the average work week plunged. Worse still, the labor force participation rate and the employment to population ratio (both of which tell the ultimate truth about the US labor market) did not improve at all; both hovered at multi-decade lows.

Several months ago, we highlighted a trading opportunity in the US Treasury market. When interest rates on the 10 year note hit 3.0%, the opportunity for low risk profit presented itself. How did this turn out? Well rates proceeded to fall to under 2.6% in only two months. The return on this trade (price appreciation and interest earned by buying the 10 year note) was over 3% in those two months, so on an annualized basis, this was a 20%+ return.  This isn’t bad especially when one considers the downside, which is limited by the Fed’s promise to keep rates low for an extended period of time. This means years.

Today, rates on the 10 year note have returned to 2.8% creating another opportunity to go long medium term US Treasury notes. With stock market prices at all-time highs, any type of correction (moderate to strong) would likely create a flood of dollars into the Treasury market driving prices up much higher. Also, US Treasury rates are now about 100% higher than they were at their lows in 2012 and 2013. This means that rates wouldn’t have to fall into uncharted territory for significant price appreciation to happen. Finally, the German 10 year note is yielding only 1.6% and the Japanese 10 year note is yielding a mere 0.6%. And the finances of both these states (certainly not Japan’s) are not better than that of the US. So if these two sovereign notes are yielding a fraction of the US note’s yield, then there’s a lot of room for them to converge—for the German and Japanese rates to rise and/or the US rate to drop.

Once again, there’s no guarantee that this will work out, but buying the US 10 year note today—for a trade—may turn into a rewarding trade……again.

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