Why A ‘Rate Hike Tantrum’ Will Not Kill Bond ETFs In 2015

The 10-year Treasury note is the most recognizable, and most important, debt instrument in the world’s financial system. It is vital to foreign jurisdictions, banks and investors as a way to gain exposure to the U.S. dollar as well as interest payments backed by the full faith and credit of the U.S. federal government. Stateside, the direction of the 10-year yield is highly correlated to the direction of mortgage rates and other popular loans. Lender interest rates tend to rise or fall in concert with the “U.S. 10-year.”

Similarly, a rising yield on the 10-year treasury often reflects a perception that the future for the U.S. economy is brightening. In contrast, when there are more buyers than sellers of the ever-prominent note – when yields are falling – the economic outlook may be dimming.

Is it that simple? Maybe decades ago. In today’s global investment community, however, central banks like the Federal Reserve can create demand artificially. The Fed’s quantitative easing (QE) actions – purchasing market-based assets with electronically created currency – pushed yields lower from early May 2009 to early May 2013.

10-Year For 5 Years

Then came the infamous “taper tantrum.” The Fed had inadvertently signaled an intent in May of 2013 to begin winding down, or tapering, asset purchases over the course of 2014. Short sellers pounced. Bond holders panicked. And the 10-year yield catapulted from the 1.5% level to the 3.0% by year-end 2013. Popular treasury bond proxies like iShares 7-10 Year Treasury (IEF), iShares 10-20 Year Treasury (TLH) and iShares 20+ Treasury (TLT) promptly lost anywhere from 8%-18% in a matter of eight months.

10-Year May 2013 To Year-End

At the end of 2013, virtually every economist on record predicted that treasuries would continue to lose value and that the 10-year yield would continue to rise. I endorsed an unpopular and completely contrarian point of view that yields would fall. Did I have an inside scoop that the world’s most respected economists didn’t have? Hardly. I reached a three-pronged conclusion that pointed to a sharp retreat for the yields on longer-term maturities. First, the world economy had been struggling so badly outside the U.S., foreign banks, sovereignties, money managers and investors, would be clamoring for the safer haven and relative value of U.S. treasury debt. Second, once the shock of the “taper tantrum” subsided, it would become evident to market watchers that the Fed had not stopped buying large quantities of U.S. bonds; they’d still be creating artificial demand throughout 2014. Third, household debt servicing as well as government debt servicing would likely drag on the U.S. economy if somehow – some way – the 10-year yield did not revert to a more viable range (2.0%-2.5%).

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ETF Expert is a web log (”blog”) that makes the world of ETFs easier to understand. Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser ...

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