Long-Term Treasury Securities have taken a massive hit over the last few months, with the yield on the 20-Year instrument increasing from 4% to 4.7% in less than eight weeks. This comes as a surprise to many bond traders, considering the Fed opted to cut rates by 50bps in September and signaling two more rate cuts before the end of the year.
Yesterday, Fed Chairman Powell confirmed the market’s prediction and cut another 25 basis points at the November meeting, adjusting the target rate from 475-500bps to 450-475bps. As of today, Fed Funds futures indicate a 64.6% chance of another 25bps rate cut in December, but are still factoring in the possibility of a pause and maintaining a target rate between 450 and 475 bps according to the CME’s FedWatch Tool.
Although treasury yields are determined by the market, they are heavily influenced by the Fed. So, although we are now officially in a cutting cycle, economic data can influence the market’s perception of the future and therefore how the Fed will respond. In times of high economic stress, the Fed will ease monetary conditions by cutting rates and making money less costly to borrow. This form of stimulus incentivizes companies and consumers to borrow and spend more, thus supporting economic growth. Although by most measures, the economy is still in decent shape, lower inflation and CPI figures are what prompted the first rate cut – now that the Fed has made a dent in its battle against inflation, tight monetary conditions are no longer necessary.
However, if new reports show data contrary to the market and the Fed’s expectations, yields and interest rates can shift dramatically, even in a cutting cycle. This is exactly what we witnessed on October 4th when the unemployment data came in lower than expected at 4.1% vs. the 4.2% forecast. The natural stability in the labor force triggered a selloff in treasuries now that traders expected the Fed may not have to intervene as much to maintain its dual mandate of maximum employment and stable inflation.
The CPI and Inflation report on October 10th prompted a further selloff in the bond market and a massive increase in yields. Core inflation came in hotter than expected at 3.3% vs. the 3.2% forecast and overall inflation came in at 2.4% vs. the 2.3% estimate. Similar to the effect the jobs report had on the market, these figures told investors that the Fed may actually be more likely to pause their rate cuts to ensure that prices are kept under control.
Furthermore, the recent presidential election has shifted investors into more Risk On assets like stocks and crypto. Without diverting into politics, it is generally agreed that Trump’s plan for massive personal and corporate tax cuts is bullish for stocks but increases concern over the viability of the national debt, and therefore the treasury market, particularly those of longer durations that carry more interest rate risk. Additionally, the expected decrease in government revenue as a result of tax breaks has raised concerns about the actual possibility of default on long-term government issued debt instruments and the potential debasement of the U.S dollar as the global reserve currency. These are, of course, extreme scenarios, but anything is possible over the course of several decades.
For these reasons, Treasuries continued their slide on Wednesday morning following the results of the U.S election, with the iShares 20+ Year Treasury ETF, TLT, gapping down over 3% at the market open. Although the fund closed up slightly off its daily lows, it still closed down 2.74%, equivalent to approximately a 3 standard deviation move, meaning that this daily selloff was worse than more than 99% of all daily moves in its history. At its low on November 5th, 2024, the ETF was down over 11% from its September high just before the first rate cut.
Although it easy to explain why something moved with the benefit of hindsight, there are still many anomalies persisting with interest rates. When we hear economists and financial analysts say that the yield curve is now un-inverted, what do they actually mean? A normal yield curve is one that offers higher yields for longer-duration securities, and an inverted one offers higher yields on shorter-duration instruments. So even though the 2-year yield is now officially below the 10-year yield – this would be considered a “normal” yield curve – there are still other durations lower yielding relative to the front end of the curve.
Many financial legends, including Stanley Druckenmiller, Paul Tudor Jones, and Jeffrey Gundlach have cautioned about investing toward the back end of the treasury curve, despite the slightly higher rates offered in the 20 and 30-year maturities, simply because of the greater investment opportunities offered primarily in the equity market under a new administration and concerns over debt levels relative to Gross Domestic Product. As Jerome Powell said during this week’s FOMC Meeting, current debt levels are sustainable, but the growth rate in debt is not.
At the end of Q2, the national debt approached a whopping $35 Trillion, or approximately 120% of U.S Gross Domestic Product. Although the ratio is down from the spike following the global pandemic in 2020, debt levels in excess of 100% of GDP are extremely worrisome for those skeptical of the government’s ability to cutback its spending.
Even though Sonic Capital still maintains substantial long exposure to the back end of the treasury curve, it is certainly not our intention to hold the debt to maturity for 20 years. And, even though the concerns raised by Wall Street’s best hedge fund managers are certainly valid, there do seem to be some viable opportunities in the government debt market, depending on how it’s played. Furthermore, these issues seem to be long-term and grounded largely in political uncertainty. It is our approach to follow the adage “don’t fight the Fed” and operate at their direction in the treasury market thinking of the Fed Funds rate having an almost magnetic effect on yields.
With Sonic’s specialty in derivatives, a majority of our accounts maintain long exposure to the back end of the curve in the form of long-term, deep in-the-money call options on the leveraged treasury fund, TMF. Although this strategy arguably adds leverage on top of leverage, with proper position sizing, this method seems to offer the highest degree of “capital efficiency”. For instance, a $30 strike call option expiring in January of 2027 is trading for approximately $25 per contract, for a total capital outlay of $2,500. This investment gives full control of $4,800 worth of the underlying ETF, which being leveraged controls about $14,400 worth of long-term treasury securities. So, these options offer full upside over the course of two years, with risk limited to the premium paid.
These positions are, of course, subject to change as new data, opportunities, and market reactions drive our decisions, but as we come out of a bear market in fixed income, this area does appear to be particularly attractive if approached cautiously.
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