"It's 2-Year Yields, Not 10-Years, We Worry About Most"

Earlier today, we showed that according to a growing number of traders and strategists, "the scariest chart for investors" is not the 10Y, and whether or not it is below or above 3%, but rather a chart showing the relentless creep higher in the 2Y Treasury note.

Commenting on the surge in 2Y rates to the highest since 2008...

... Academy's Peter Tchir said that "the 10-year yield might attract all the attention but higher short-term yields are more problematic." He added that "consumers who want to purchase large items are faced with higher costs. Investors can allocate to less risky bonds and out of dividend stocks and still get some yield."  Jefferies economist Thomas Simons said that "it’s absurd that everyone is falling all over themselves talking about the 10-year at 3 percent,” said "how about the one-year bill at 2.20?"

Now, completing the trifecta of warnings that it is not the 10Y but the 2Y that is far more worrying, is DataTrek's Nick Colas who writes in his latest later to subscribers that "despite all the headlines, it’s not the yield on 10-year bonds we worry about most. Two-year Treasuries offer reasonable (and safe) returns for the first time in a decade. Tied as they are to Federal Reserve policy, they will only stop rising once markets feel they have the central bank’s intentions fully baked into bond prices."

In his full note below, Colas explains why the higher 2Y yield rise, the greater the pressure on risk assets, which includes stocks:

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Tempted By The 2 Year (Yield) Itch

It’s not the yield on the 10-Year Treasury note we worry about most in terms of near term stock market performance. It’s the 2-Year. With a yield of almost 2.5%, this paper offers twitchy equity investors a viable option for capital allocation. Plenty are making the switch, as ETF money flow data clearly shows.

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There’s a lot of stock market angst around the fact that the 10-Year US Treasury now yields 3%. Yes, long-term risk free rates inform the discount factors used to value equities so valuations decline as yields rise. But in terms of capital allocation, it would take an inveterate stock bear to argue that the S&P 500 can’t compound returns at better than 3% for the next decade. Yes, stocks will be riskier… But over that horizon history says equities are the way to go.

Rather, we believe that it’s the short end of the curve – specifically 2-Year Treasuries – where the calculus gets more difficult. While we are more positive on US stocks than this argument portrays, consider some basic market math:

  • The S&P 500 sits at 2,635 tonight, off 1.5% YTD. Markets have been choppy. The year-to-date highs were in January, which feels like a long time ago. Great earnings reports aren’t helping much. Things feel heavy.
  • If I offered you a no-fee risk-free contract to deliver a 2.5% annual return on the S&P over the next two years, would you take it? On the one hand, it’s well less than the historical market return. But… There’s no risk of drawdowns and at least it’s better than 2% inflation. You might be tempted.
  • That is the sales pitch for the 2-Year Treasury, which yields 2.49% today.

Money flow data (courtesy of www.xtf.com) for US listed exchange traded funds show there’s something to this argument:

  • Over the last month, redemptions out of US equity ETFs total $868 million.
  • In the same period, ETFs that invest in short term (less than 3 year maturity) fixed income instruments have seen $5.2 billion of inflows.
  • Bond ETFs dedicated to longer maturities saw smaller inflows over the last month: just $1.5 billion.
  • The YTD numbers show a similar story, with $10.3 billion of inflows to short term bond ETFs and $6.2 billion into US equity products. Long term bond ETFs come in a distant third at $1.2 billion of inflows.

Readers with a long memory may also recall the following:

  • At the top of the last cycle (2006-2007), 2-Year Treasuries yielded right around 5% (give or take 50 basis points).
  • As is the case now, yields here had come a long way from their recession lows of 1.3% in 2003.
  • If you had bought 2-Years any time in the first half of 2007, you would have clipped 24 months of 5% annual coupons and received your return of principal just in time to buy the equity lows in the first half of 2009.

As much as every investor knows market timing is very difficult, that’s the sort of case study that resonates just now.

Bottom line: despite all the headlines, it’s not the yield on 10-year bonds we worry about most. Two-year Treasuries offer reasonable (and safe) returns for the first time in a decade. Tied as they are to Federal Reserve policy, they will only stop rising once markets feel they have the central bank’s intentions fully baked into bond prices. We should be getting close on this count. But we understand why investors are shifting capital to 2 year paper and avoiding incremental equity risk just now.