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Interest Rates Are on the Move to the Upside; Watch the Bond Market

I can’t stress this enough: watch the bond market because the U.S. Federal Reserve and central banks around the world are talking about raising their interest rates.

Last weekend, I met up with a friend of mine. Every time we meet, we talk about nothing but markets. We always talk about where the next big move is going to be, and how it will look.

A little background: while we both started out as equity traders at a proprietary firm, we parted ways a few years back. He went on to do investment banking, and he is now at a private equity firm. So, he is very well versed in the markets and economics.

This past weekend, the bond market was the topic of our discussion.

In case you didn’t know…

Bond yields have increased immensely as the Federal Reserve has started to raise its benchmark interest rates. In the last year:

• One-year U.S. Treasury yields increased close to 111%.
• Two-year U.S. Treasury yields increased 101%.
• 10-year U.S. Treasury yields increased 38.6%.

Here’s one more thing: the 10-year yields stand at a very critical level. They were trending downward since the 1980s. These yields are currently making a solid run to the upside, and the 30-year+ trend could be broken very soon.

See the chart below for some perspective.

Chart courtesy of StockCharts.com

No matter how you look at it, it appears that higher interest rates are creating problems for the bond market.

30-Year-Old+ Trade Isn’t Working Anymore

Back to my conversation…

My friend Steve said to me, “You do realize, at the major trading desks around the world, there are traders sitting there who have never seen bond yields go higher.”

He added, “The trade was very simple for them. You bought bonds, and they did well. Your portfolio looked great.”

When bond yields go down, it means that bond prices have increased.

“How are they going to act when they figure out that the 30-year-old+ trade isn’t working anymore?” asked Steve.

What’s Next?

You see, dear reader, this is a very valid question and no one is really talking about it.

Over the past 30 years, bond investors have had a really great time.

Thanks to central banks, interest rates were moving lower. This only made the bond trade easy. After the financial crisis of 2008–2009, central banks even started to print money and they lowered interest rates to zero. This made bonds a no-brainer trade.

After a while, we could be entering a period when interest rates are rising, bond prices are crashing, and bond yields are surging. How will the complacent investors and traders react to all this?

I believe we could be entering a very scary period.

I completely understand that readers of Lombardi Letter may not be interested in bonds. However, it’s important to keep in mind that the bond market is huge.

According to the Securities Industry and Financial Markets Association (SIFMA), at the end of 2017, there were almost $40.8 trillion worth of bonds outstanding in the U.S. alone. (Source: “Outstanding U.S. Bond Market Debt,” Securities Industry and Financial Markets Association, last accessed May 17, 2018.)

Globally, the bond market is much bigger.

I will also say this: the bond market impacts consumers on a daily basis. The stock market doesn’t do that as much. For instance, when someone goes to apply for a mortgage, they could be directly impacted by what’s happening in the bond market.

Obviously, with time we will know more. But don’t ignore bonds at times that interest rates are surging. They could be a source of volatility and a lot of uncertainty in the coming quarters and years. Investors beware.