By now, you know that the 10-year U.S. Treasury yield breached 3 percent for the first time in weeks. It climbed as high as 3.03 percent on Tuesday, a level not seen since May, when it touched a seven-year high.
The attention heaped on the global borrowing benchmark is warranted, of course. But for fixed-income investors, a crucial piece of context is what’s happening with shorter-term yields, which also seem to be on a glide path toward 3 percent.
Seven-year Treasuries actually broke through that mark in May, hitting 3.08 percent. The five-year yield didn’t quite get there, topping off at 2.95 percent (it’s at 2.92 percent now). Two- and three-year Treasuries set new 10-year highs this week, at 2.79 percent and 2.86 percent, respectively.
This may seem like a long way of saying that the U.S. yield curve is extremely flat. But it’s instructive to break out each maturity because of their respective total returns this year, and the prospect for further gains in the weeks and months ahead. Ultimately, it comes down to a dilemma over duration, which measures sensitivity to changes in interest rates.
Take two-year Treasuries. Their yield has increased steadily this year, climbing about 90 basis points. Given that prices and yields move in opposite directions, those notes would seem like a losing wager.
That analysis would be wrong. In fact, two-year Treasuries have eked out a 0.14 percent return year-to-date, according to ICE Bank of America Merrill Lynch data. Granted, that’s not much – but it’s better than taking losses like every longer maturity. Though 30-year yields are below their 2018 highs, only rising about 40 basis points this year, the debt has still declined by 5.6 percent. Even if this isn’t a full-fledged bond bear market, long duration has stung investors.
But now, several rate hikes into the Federal Reserve’s tightening cycle, the outlook gets tricky. The central bank is set to raise interest rates again next week, then possibly again in December. A further two increases are likely next year. After two more hikes, the fed funds rate would have an upper bound of 2.5 percent. After four, it would be 3 percent. To most policy makers, the neutral, long-term rate is between 2.75 percent and 3 percent.
That range is just about where Treasuries from two to 10 years currently trade. The question, then, is what’s the best part of the market to hold for the next move in rates, given how much is already priced in? The latest Commodity Futures Trading Commission data isn’t very insightful, because asset managers are at, or near, record net long positions across the board, while hedge funds and other large speculators are net short across maturities.
Owning the front-end of the curve is the safe play. Bank of America’s two-year Treasury index has never posted a negative annual return in data going back to 1988. Given the Fed’s gradual pace, it probably won’t in 2018, either. On the other hand, timing a new peak in 10-year U.S. yields could provide a quick, sizable windfall for traders. This is the third time since the end of May that Treasuries have tested the 3 percent level. Relative strength index analysis, which measures market momentum, indicates that 10-year Treasuries are close to “oversold.”
Something will have to give on the yield curve. Bond traders have been reluctant to push the spread between two- and 10-year Treasuries closer to zero, with yields on the two maturities rising largely in tandem over the past two weeks. At this point, both maturities are close to the levels that analysts expected they would be at the year-end, according to a Bloomberg survey.
The best bet might be somewhere in the middle of that curve. If five-year yields reach 3 percent, that’s pretty good, if you think the Fed will have a tougher-than-expected time tweaking its guidance when policy is “neutral” instead of accommodating. In the post-crisis world of central banking, there’s no clear marker for when that shift will happen.
Heading into the home stretch of 2018, with yields coalescing at about 3 percent, bond traders face a tough choice on duration. When the ink dries on the total returns for the year, you will know who got this moment right.
— For more Bloomberg Opinion columns, visit http://www.bloomberg.com/opinion.
Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.