The Yield Curve Trade (TLT)

Some fancy-pants at a bigwig brokerage recently dreamed up with the term “The Great Rotation” to describe a phenomenon that we’ve grown hoarse yelling at y’all for the last two years.

The idea is simple, and it goes like this.

The 30 year bull market in U.S. Treasuries is coming to an end, interest rates are set to back up significantly (due to pending inflation from all the liquidity in the system) and money will therefore shortly be exiting the fixed income arena for lusher pastures in equity land.

Truth is, we wish we’d thought of the term ourselves.

Alas, our pants just aren’t fancy enough.

Enough bourgeois blather, McAbby! Get on with it!

Coming up with catchy phrases is not our first order of business here at Bourbon & Bayonets. Oh, no. We’ve rather been charged with the Atlas-like task of educating and entertaining our vast readership toward better investment returns in what’s shaping up to be perhaps the most difficult era to partake in the money game.

And with a few minor exceptions, we feel we’ve done our part reasonably well. It’s with genuine humility that we report that our direction and recommendations have been uncannily and consistently on the mark.

So if we’ve succeeded in convincing you that a long stock market position – despite the fiscal cliffs and debt ceilings, the hard Chinese landings, the Greek and Spanish and Italian and Irish sovereign debt imbroglios, the Arab springs and whatever the hell else you want to throw in there – was the right thing to do, then we’ll be partially satisfied with our work to date.

By the way, this is what you were worried about exactly one year ago:

Be happy.

Where we may have fallen short, however, is in convincing you of the need to be out, if not outright short, of the fixed income field.

In truth, we’ve devoted a good measure of space to the issue and have written with increasing urgency on it, too. But it appears the laggards amongst you require yet another tear of the lash before they understand the sweet truth of the upcoming bond bear.

So here goes.

Let’s begin with the following incontestable fact.

When interest rates rise, longer term bonds sell off in more violent fashion than shorter term bonds.

We won’t get into all the mathematics of it. Just suffice to say that the risk associated with holding a fixed rate, long term instrument in a rising rate environment will prove more costly than that of a shorter duration, because the short term bond can be reinvested at a higher rate earlier. The opportunity to catch a better rate of return sooner in the process makes the current value of that instrument less subject to the volatility that obtains with longer term instruments.

And, of course, there’s money to be made from this understanding.

Yield Curve Rising

Let’s broaden our understanding somewhat with a look at the U.S. Treasury yield curve for 19 February, 2013 (Tuesday), on a chart that indicates both nominal and real yields offered for all durations.

[The Treasure Department offers the above chart here for all interested.]

And what do we see?

First, that investors have to go out nearly twenty years (red circle) to get a positive rate of return on their investment (real yield is nominal yield less the current rate of inflation).

This in itself is almost unfathomable. It means that the vast majority of bond buyers today are prepared to purchase an asset that will lose money over time (due to inflation) in return for the ‘guaranteed’ return of their principal.

Shocking.

That’s what we call a cataclysmic mindset. And because bond yields are backing up, those same petrified bond-holders will see their apocalyptic fears eventually become a reality. The value of their bonds will plummet – again, with the long end of the curve seeing the worst of it – and they’ll lose out to inflation, while the opportunity to more profitably deploy those same resources will be lost.

Big Players Repositioning

The banks and brokerages, on the other hand, have recently repositioned themselves for the coming storm, reducing their duration and thereby eliminating much of their reinvestment risk. As short term rates push higher, they’ll be better configured to regularly turn over their maturing funds into higher rate bearing instruments.

And that, for us, makes the trade abundantly clear.

Have a look at the long term (20+ Year) Treasury bond ETF (TLT) against the 3-7 Year (IEI).

Since mid-summer IEI has lost just over 1% of its value, versus 11% for the long bond, TLT (red circles, at top). And TLT’s Relative Strength Indicator is nowhere near oversold (at bottom, in blue), signalling there could be plenty more selling down the road.

Given all the foregoing, we see no reason why the trend shouldn’t continue.

A long/short trade using IEI (long) and TLT (short) will cost you about $6 per share paired.

It’s worth a look.

There’s a bid for the short end of the curve.

There ain’t nothing out at the end.

Many happy returns,

Matt McAbby, Senior Analyst, Oakshire Financial