Don’t Go Chasing Waterfalls

Articles From: WisdomTree U.S.
Website: WisdomTree U.S.

By:

Head of Fixed Income Strategy

What a whirlwind week for the bond market. Investors were greeted with an historic Fed rate hike, another 40-year high for inflation and a second consecutive negative quarterly reading for real GDP—in other words, a technical recession. There’s no doubt these conflicting storylines present a confusing backdrop for fixed income investors when positioning their bond portfolios. My advice: don’t go chasing waterfalls.

Prior to last week’s disappointing Q2 real GDP report, there had been increasing discussion about whether rates, such as the UST 10-Year yield, had peaked and was it now time to ‘go longer duration.’ Obviously, the back-to-back negative readings for the economy gave that narrative something of a jump-start, as the UST 10-Year yield continued its descent to lower territory.

There are two very important considerations to keep in mind when addressing this question. Obviously, the first element is whether bond yields will rise again from current levels, fall further or, at best, remain stable. My concern revolves around the incredible volatility and whipsaw pattern the UST 10-Year yield has shown in the last three months. As highlighted by the graph below, investors have witnessed the UST 10-Year yield go from close to 3.25% back down to 2.75%, only to see it then rise to about 3.50%. It is now back to around 2.60%. 

U.S. Treasury 10-Year Yield

U.S. Treasury 10-Year Yield

Typically, this is not the type of volatility an investor wishes to see in their bond portfolio. And I’m in the camp that believes this elevated volatility will remain a part of the investment landscape during the second half of this year.

Against this backdrop, one has to wonder if the UST 10-Year yield has gotten ahead of itself a bit. From a monetary policy perspective, the Fed seems poised to continue raising rates this year. Quantitative tightening (QT) will soon be kicking into high gear, and as we’ve continued to see, inflation will more than likely remain ‘sticky.’ And, if you believe the latest economists’ projections, real GDP could bounce back into positive territory in Q3. Most estimates are placing growth for this quarter around the 2% vicinity.

U.S. Treasury Yields

U.S. Treasury Yields

The second consideration is whether an investor is being compensated for the potential added interest rate risk by moving into longer duration. Quite a lot of attention has been centered on how flat and/or inverted the shape of the Treasury yield curve has become (see above). In other words, the present UST 10-Year yield level offers little, if any, cushion for potential mistakes that could result in another move to the upside. 

Interestingly, UST floating rate note (FRN) yields have now closed the gap. They are currently higher than 3-month t-bills and within striking distance of the 5- and 10-Year maturities. To provide perspective, the UST FRN yield is only 13 basis points (bps) below the UST 10-Year rate but carries a duration profile of just one week.

Conclusion

With the Fed expected to continue raising rates during its three remaining FOMC meetings this year, it is very likely UST FRN yields could match, or even exceed, some fixed coupon securities along the Treasury yield curve in the not-too-distant future.

Originally Posted August 3, 2022 – Don’t Go Chasing Waterfalls

Important Risks Related to this Article

There are risks associated with investing, including the possible loss of principal. Securities with floating rates can be less sensitive to interest rate changes than securities with fixed interest rates, but may decline in value. The issuance of floating rate notes by the U.S. Treasury is new and the amount of supply will be limited. Fixed income securities will normally decline in value as interest rates rise. The value of an investment in the Fund may change quickly and without warning in response to issuer or counterparty defaults and changes in the credit ratings of the Fund’s portfolio investments. Due to the investment strategy of this Fund it may make higher capital gain distributions than other ETFs. Please read the Fund’s prospectus for specific details regarding the Fund’s risk profile.

Disclosure: WisdomTree U.S.

Investors should carefully consider the investment objectives, risks, charges and expenses of the Funds before investing. U.S. investors only: To obtain a prospectus containing this and other important information, please call 866.909.WISE (9473) or click here to view or download a prospectus online. Read the prospectus carefully before you invest. There are risks involved with investing, including the possible loss of principal. Past performance does not guarantee future results.

You cannot invest directly in an index.

Foreign investing involves currency, political and economic risk. Funds focusing on a single country, sector and/or funds that emphasize investments in smaller companies may experience greater price volatility. Investments in emerging markets, real estate, currency, fixed income and alternative investments include additional risks. Due to the investment strategy of certain Funds, they may make higher capital gain distributions than other ETFs. Please see prospectus for discussion of risks.

WisdomTree Funds are distributed by Foreside Fund Services, LLC, in the U.S. only.

Interactive Advisors offers two portfolios powered by WisdomTree: the WisdomTree Aggressive and WisdomTree Moderately Aggressive with Alts portfolios.

Disclosure: Interactive Brokers

Information posted on IBKR Campus that is provided by third-parties does NOT constitute a recommendation that you should contract for the services of that third party. Third-party participants who contribute to IBKR Campus are independent of Interactive Brokers and Interactive Brokers does not make any representations or warranties concerning the services offered, their past or future performance, or the accuracy of the information provided by the third party. Past performance is no guarantee of future results.

This material is from WisdomTree U.S. and is being posted with its permission. The views expressed in this material are solely those of the author and/or WisdomTree U.S. and Interactive Brokers is not endorsing or recommending any investment or trading discussed in the material. This material is not and should not be construed as an offer to buy or sell any security. It should not be construed as research or investment advice or a recommendation to buy, sell or hold any security or commodity. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.