Low interest rates are the lifeblood to a debt burdened economy. Back in October 2009, when 30 year treasury yields were at 4%, I suggested that getting short treasuries or selling call options on treasuries would be a good strategy for the coming months. It turns out that I made a wise call, because since then 30 year rates have risen over 60 basis points and are trading near 2 1/2 year highs. So, what comes next?
The federal reserve has been using two tactics to keep interest rates low: 1) by keeping the federal funds rate low to put a ceiling on short term interest rates 2) through asset purchase programs in which assets (mostly mortgage backed securities) are purchased by the fed to artificially increase prices and lower long term yields. The fed was especially concerned about longer term yields because the mortgage industry relies on low interest rates to increase demand for houses. When rates increase, the monthly price for a house increases proportionally and then families decide they cannot afford to purchase so they continue to rent. Lower demand puts further downward pressures on prices. The good news is that house prices staged a muted rally from mid-2009 through the end of the year.
With a muted recovery in house prices, the federal reserve has suddenly received some breathing room. In addition, the markets in general have stabilized: credit spreads have come in to pre-crisis levels, U.S. equity prices have bounced over 60% off their lows, banks have returned to profitability, and corporations have been able to roll their debt and raise equity to fix their balance sheets. Economic factors also look less bleak with a return to positive GDP growth and stability in the unemployment situation. The fed is now interested in “testing” the strength of this recovery. How does it do that? By letting long term interest rates rise to where the market thinks they should be. Think of it as an experiment. How will the fed facilitate this experiment? By slowly shutting down its asset-purchase programs.
For this reason, even though interest rates have risen quickly over the last few weeks, I believe there is plenty of room for the curve to steepen. I actually believe that long-term treasury rates could increase by 1% or more by the end of 2010 even as the short-term rate is held at or near 0%. This suggests that fixed income is at risk of large price declines as rising interest rates impact that total return. Short positions in the long treasury ETF (TLT) or treasury futures would help offset any losses on your fixed income investments. The risk to this trade is a global event that creates a double market/economic dip. In my opinion, the event would be easy to spot and the trade could be unwound before interest rates decline to crisis levels.