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  • Treasury Bond yields have soared because of the Fed's battle with inflation.
  • The recent increase in yields has them breaking out of a long-standing downtrend.
  • Bond yields could continue higher, making them an interesting alternative to stocks.

The Fed told us it would be a bad year for Treasury bonds when it announced earlier this year it would reduce the number of bonds held on its balance sheet to help curb inflation. Nevertheless, their poor performance has been jaw-dropping. The 20-year Treasury Bond ETF  (TLT)  is down 34% from its peak in December, and 2-year Treasury bond yields (yields move inverse to bond prices) have spiked from below 0.80% to 4.3% this year alone.

Bonds' rapid decline has caused steep losses for investors who built 60/40 portfolios (60% equities/40% bonds) to hedge the risk of one or the other declining. The good news is both stocks and bonds appear short-term oversold. The bad news, for now, is bond rates may remain high.

In “Rising Rates: A Break of a 40-Year Trend Should Not Be Ignored,” a look at 200 years of data leaves Real Money technician Bruce Kamich to conclude that “the downtrend of rates from 1981 has been broken.”

Kamich includes two charts to show historical trends over time. The first chart shows historical yields from 1790 through 2015 for context. Kamich writes, “In this sample of the 200-year chart (not updated with more current data), you can see that rates move up and down in a huge sideways pattern. There are definite periods of time when rates have trended both up, like from 1951 to 1981, and down, like from 1981.”

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The second chart provides data since 1994 so readers can see the trajectory of yields through this week. Kamich writes, “We can see lower highs and lower lows from 1994 to a low in 2020. Rates turned higher and broke the long-term downtrend in early 2022…The downward trend extends back to 1981 when Paul Volcker started to tighten rates and fight the inflationary trend that was raging. A break of a trend that was in force for approximately 40 years should not be ignored. (underlined and bolded for emphasis).”

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The implication is yields witnessed in 2020 were rock bottom, and the trend remains toward higher rates. Kamich notes that yields are above their “rising 40-week moving average line,” and moving average convergence/divergence (MACD) is “firmly above the zero line and rising, telling us that this trend has strength.” MACD subtracts the 26-day Exponential Moving Average (EMA) from the 12-day EMA. A bullish or bearish signal triggers when that result crosses over or below zero, or the 9-day EMA.

What’s it mean for investors?

Stimulus via rate hikes and bond buys has provided strong tailwinds for equity prices as cheap money has fueled speculation and earnings growth. With the Fed entrenched in a battle to derail inflation and increasingly global central banks joining in, the headwinds to speculation and earnings growth are stiffening.

In “Believe in a Soft Landing ... Yeah, and That Inflation Was 'Transitory,'” Real Money Pro’s Maleeha Bengali writes:

“We have been above trend and defying all economic metrics since this crazy Fed experiment started…Cheap is relative -- only if you can trust the "E" of the P/E metric. One can argue that these downgrades have yet to be reflected in the analysts' numbers. The Fed boosted trillions of dollars into markets to jump-start the economy, and that caused a demand surge, unlike in past cycles, to get all assets to reach new highs causing an inflation shock to the system. When demand moves up this much in a short span of time, the supply side is unable to catch up, but eventually, something has to give. Either demand needs to fall, or supply plays catch up. In this case, the former reached a tipping point where the economy started to roll over.”

Bengali suggests global Central Banks, led by the Fed, are between a rock and a hard place. They need to regain price stability, but their tools act only as sledgehammers to demand. Because rate hikes increase the cost of capital, they hamper investments that can increase supply. In short, the only option is to send global economies into recession and pray that demand destruction does all the heavy lifting.

That’s not great news for earnings, especially if a flight to safety means that the U.S. Dollar keeps marching to new highs, causing foreign sales at U.S. companies to shrink as they’re converted back into our currency. According to Morgan Stanley, “every 1% change in the DXY has around a -0.5% impact on S&P 500 earnings, 4Q S&P 500 earnings will face an approximate 10% headwind to growth all else equal.” Toss into the mix that companies are struggling to pass along the entirety of their rising input costs, reducing margins, and it could be an ugly earnings season.

That’s a point continuously hammered home for months by Action Alerts PLUS Co-Portfolio Managers Bob Lang and Chris Versace, including today, when they wrote to members, “the number of headwinds the market has been facing means that there's a high probability for them to impact revenue and earnings prospects for the September quarter, as well as forward guidance for the balance of 2022 and into 2023.” In short, it’s far more likely we see downward than upward earnings revisions into next year.

Investors wouldn’t be blamed if they said “no mas” to stock market volatility, embracing short-term Treasuries instead. As Real Money Pro’s Doug Kass reminds investors, the days of There Is No Alternative (T.I.N.A) to stocks are over because Treasuries Are The Alternative (T.A.T.A).

Yields have gotten attractive enough to compete with stocks for savings, particularly among risk-averse retirees who previously were forced to buy stocks because yields were, frankly, pathetic. How high could yields go?

Back to Kamich: “A swing objective (the height of the downward channel projected upwards) gives us a yield target of around 5%...Respect this trend of rising rates. A break of 40-year downtrend is a major event, and rushing to pick a peak in rates is likely to end poorly.”

The Smart Play

Stocks are taking cues from the bond market and the U.S. Dollar. Historically, bond prices find their footing when recession strikes, outperforming stocks, because of a flight to quality. However, that’s usually because the Fed’s cutting rates (or it’s neutral) to pull the economy’s yoke upward. At best, we appear months away from a shift by the Fed to neutral because inflation remains stubbornly high, and so far, unemployment — a lagging indicator – isn’t budging. Inflation has arguably decelerated, and that’s good news. Unfortunately, it’s likely to take folks losing jobs for the Fed to conclude it's done enough, and it can hit the sidelines. At that point, bonds could find more lasting footing, and eventually, stocks will follow suit because yields will have stabilized or declined.

Until then, the bear market remains the primary downtrend. There will be actionable bounces and rallies within it; however, investors should treat them like they’re from the show-me state. In bear markets, odds tilt toward selling resistance, so continue playing defense.

On the plus side of the ledger, we are moving out of the historically worst six months of the year, and typically, stocks do much better after mid-term Elections than leading up to them. It pays best to sell the first half of a bear market before widespread damage, but because nobody rings a bell signaling bear markets are over, it pays to buy the second half. What and when you buy matters, though. So, don’t overcommit, and keep those watch lists full of fresh ideas rather than 2020’s winners.

As for bonds, rising rates make short-term Treasury yields particularly intriguing, but you’ll want to own them to maturity, given the risk to bond prices remains. For this reason, you may want to tilt a ladder or barbell bond strategy toward the shorter end of the curve, where rates are juiciest. For perspective, the six-month Treasury bill is yielding nearly 4%. When bonds mature, you can potentially buy higher yields if rates stay high or continue rising, or if the worst is behind stocks, reallocate as appropriate.

Also, if you haven’t yet, you can still buy Series I Savings Bonds to benefit from a 9.62% yield over the first six months of owning them (the rate will reset, likely to a lower rate, on November 1). You’ll need to own them for one year (and if you own less than five years, forego 3-months of interest if you sell), but you’re likely to get a solid return in the next 12 months without stock volatility.

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