With the Rally in US 10-yr, Should We Lock in Longer Duration Positions?

Author: Bruce Liegel

Interest rates moved higher again last week and have more than achieved price objectives that have been discussed for the past 6 months. Last week oil was the focus from a longer-term perspective — this week the US interest rate market will be front and center.

Since the stock market crash in 1987 the US 10-yr has been in a declining channel as shown in Chart 1 below. Rates have since declined from over 9% to a low of just below 50bps in 2020 – a decline that has taken over 30 years. The largest rally in price during this decline was in 1993-1994, which was 2.8%. There were a few other rallies above 2%, but none greater than the 1993 rally. The current rally in rates is now approaching 5%, which is by far the largest rally in the 10-yr in over 30 years. This indicates an obvious change in trend, and opens the door for a much larger move in interest rates over the next 5-10 years. Refer to previous deep dive “The Carry in the Conundrum”, for a more in-depth research on this generational trend change

Chart 1: US 10-yr Rates

The previous long- term change in interest rates (higher rates) took place from 1945-1981, as shown in Chart 2. In that bear market in bonds, rates went from 2% to almost 16%, and took about 35 years. That’s why I mean this bear market in bonds (higher rates) is just getting started. While interest rates have moved sharply higher the past couple years and are due to correct, Chart 2 puts the long- term history into perspective when looking at what has occurred in the past and what may happen in the years ahead. Interest rate cycles take a long time to play out and are generational changes for most societies. They are major turning points that bring on massive upheavals — this one is even more pronounced because of the available cheap debt that allowed unwise financial decisions to be made over the past 10 years. The punch bowl has been pulled away, and we are now just starting to see the areas of hemorrhaging that were caused by first a very loose monetary policy and now interest rates moving sharply higher. 

Chart 2: US 10-yr Rates (1900 - present)

As mentioned earlier this increase in interest rates is by far the largest in over 30 years, but is nearing an end. The 5-wave pattern from the 2020 low is now almost complete, with the market approaching key technical areas of resistance. Referring back to Chart 1, the 50% Fibonacci retracement level for the channel pattern is around 4.94% – the Fib levels are on the left side of the chart.  The orange horizontal line represents the old highs from just prior to the 2008 stock market crash — so a very relevant period of time. Could we go higher? Possibly, but these key data points and the increasing economic risk should cause the market to correct or pause from these levels. 

Locking in longer duration positions now makes a lot of economic sense — maybe not out 10 years, but I think 3 years and in is warranted, if 5% works for you, maybe even 5 years. If our price projections are correct, the next correction could easily take 10-yr rates back 50% from here, or to around 2-3%. This puts the next tightening cycle a few years away from today, and by locking in some duration today, it will allow the ability to weather the storm when rates are lower.

The yield curve is now also moving much higher, closing at -15 bps last week. It is another indicator that has been highly accurate in predicting upcoming economic slowdown — but quite dismal the past 12 months. Chart 3 and 4 show the two interest rate spreads that I watch. The 2-yr vs the 10-yr in Chart 3 and the 3-month vs 10-yr in Chart 4. Notice both had never traded as low as they did this past year over the 35- year history of the data. 

Chart 3 : 2-yr vs 10-yr

Chart 4   3-month vs 10-yr

These extreme low-levels of the spreads signal the panic in correcting the mistakes of the easy money policies over the past 10 years — never have interest rates been kept so low for so long as they did. This furious tightening of the front end was brought on by pure panic by the global central banks (Japan excluded). The market always concludes that the central banks tighten until something breaks — signs are beginning to show that stuff is breaking.

One final topic to discuss is the concept of “Term Premium” that is once again front and center in the financial media. Chart 5 shows the value that is calculated by the Federal Reserve Bank of NY. It’s an ominous calculation, with no one really knowing what it is, as it’s a fudge value that is used to fill out the unexplained level of interest rates, typically in the longer end. It’s really driven by what inflation expectations are for market participants in the 5-10 year forward period. But for most, this is a guess and only a guess. How many Fed Phd’s got this inflation cycle right?

Chart 5: Term Premium

But there is an easy way to see what term premium is, and that is by just looking at what inflation expectations are. Chart 6 shows the overlay of the NY Fed’s Term premium in blue and the Cleveland Fed’s value for 5-yr inflation expectations in orange. They are highly correlated and have moved in tandem over the past 35 years. So when you hear the word “term premium” just think about inflation expectations, and know that even this number has very little forecasting ability.  

Chart 6   NY Fed’s Term Premium (Blue RHS) vs Cleveland Fed’s 5-yr Inflation Expectations (Orange LHS)

Final note on stock markets, and I will focus more for next week, but for now I leave you with Chart 7 below, I was hoping for one final push higher in global equity markets (after this corrective phase was complete), but the July high might have been the hurrah! The SP500 is right on major support, marked by the light blue up trend line and the dark blue horizontal line. If these fail, and it looks precarious – the market could see a drop of 10-15%. The price target for the SP500 would be the lows from Sept 2022 at 3600. The Nasdaq has a lot more room to fall if we truly do see a washout. 

Chart 7: SP500

Appendix

I am also setting out a few charts below that I am watching.

Trading strategy is based on the author's views and analysis as of the date of first publication. From time to time the author's views may change due to new information or evolving market conditions. Any major updates to the author's views will be published separately in the author's weekly commentary or a new deep dive.

This content is for educational purposes only and is NOT financial advice. Before acting on any information you must consult with your financial advisor.