Investment Outlook by Kelley Wright | IQ Trends

Investment Outlook

Inverted or Steepening Yield Curve on the Horizon?

Could 30-Year Treasuries Rise Above 4%?


“Missing the forest because of the trees” is an oft used adage for focusing on the wrong aspect of a situation, and, consequently, overlooking a more important aspect of the same situation.

What brought this phrase to mind was a text I received from my good friend Scott Davenport with Mother Merrill in Knoxville. Scott was a floor trader in Chicago for years before moving “upstairs,” and perhaps the best technical analyst I know. His analysis and “feel” is almost uncanny, and time and again his calls have proven to be some of the most prescient I have ever seen.

What Scott texted me was some activity he was seeing in the futures market on the 10-year and 30-Year Treasury bonds. My initial reaction was, “what is this about?” What followed was a 30-minute phone call where Scott detailed his analysis of this activity and what it could mean for bond yields.

To make a long story short, what the action was suggesting on the charts is that the 10-Year Treasury, which everyone and their brother is focusing on, is close to finishing its upside move in yield and downside move in price. What makes this such a head scratcher is the Fed is on record for wanting to raise Fed Funds another two or three times this year, which would necessarily push all short-term yields higher. If the Fed does raise two to three more times, and all the important shorter-term yields, meaning 2-years, 5-years, etc., all move higher, but the 10-Year doesn’t move much above 3.0%, it would make for a pretty flat yield curve. And, once the yield curve goes flat it’s just a walk in the park to an inverted yield curve, which nobody wants to see.

Okay, stay with me here. The Fed, of course, knows an inverted yield curve is bad news, which begs the question of why they would continue to push short rates higher. The answer? The 30-Year Treasury is going to go higher.

If Scott’s math and the charts are right the projected yield for the 30-Year comes in about 4.25%. If that comes to fruition we don’t have an inverted yield curve, we have a steepening yield curve, and an entirely different ballgame altogether.

The sole purpose of QE was to keep the yield on the 30-Year down, which pushed all other yields lower. There were a lot of benefits to a low-yield regimen: Mortages, if you could qualify for one, were dirt cheap; corporations were able to refinance their debt at generational low yields, which allowed them to repurchase large quantities of stock and increase dividends, all without any real earnings! The banks could borrow at next to nothing, charge a lot on credit cards, auto loans, and student loans, and fix up their balance sheets.

Most importantly it bought time for the global financial system to heal. Now that there appears to have been sufficient healing, the Fed, and believe it or not the European Central Bank, have started the process of normalization. And, by normalization I mean letting interest rates rise.

With the central banks no longer purchasing vast quantities of sovereign bonds and mortgage backed securities, there will be fewer buyers in the fixed-income market. With fewer buyers there will be a greater supply of fixed-income securities. Unless there is sufficient demand to soak up the supply prices will drop, and yields will rise until the yields reach a sufficient level to attract buyers. This is how normal markets work.

With higher bond yields there will be an increased cost of capital to build factories, develop new lines of products and services, and hire and train new employees. These are the real-world ramifications that no one is talking about.

Additionally, bond buyers will have to adjust to new ranges of short-term, medium-term and long-term maturities, which will be most prevalent in the institutional market. Lastly, dividends will have to compete with the higher returns available from fixed-income instruments. What this means is change, which often isn’t pleasant, especially for the entire generation of investors that have no experience beyond picking ETF’s and thinking they’re a genius. Oh my, are they in for a surprise.

Of course, nothing is going to happen overnight. You can’t turn an aircraft carrier around in a stream. The 30-Year isn’t going to go straight up, it will probably take until the end of this year and perhaps into early 2019.

Segments of the market will start to adjust though. Look at the results of our Online Reader Poll. Trendphiles are die-hard stock buyers, yet a significant percentage of Poll respondents said if rates become competitive they will allocate a higher percentage of their portfolio to fixed-income than I would have thought. Now consider investors that aren’t as avid stock fans as Trendphiles are.

It isn’t a huge leap to think they will be even more inclined to move into fixed-income.What this portends for stocks is that dividend yields will have to increase. For dividend yields to increase earnings have to increase or stock prices will have to decrease.

For high-quality companies with long-term track records of performance, generating higher earnings by providing consumers with products and services they want and need should not be a problem. This is, after all, what they do – giving the consumer what they want.

The Challenge for Investors

The challenge for investors will be to be selective in their investment considerations. The ability to identify quality and recognize value will be paramount. For those who have relied on the shotgun approach, well, you better learn how to use a rifle. The good news for the enlightened investor is this is how we make our living in the stock market. Our Criteria for Select Blue Chips allows us to identify high-quality companies and our Profiles of Value inform us to when their dividend yields indicate whether to buy, sell, or hold.

Personally, I find this an exciting time to be a stock market investor. With the markets recovering from a long-period of central bank intervention, our tools should allow us to do what we have done consistently for fifty plus years – out perform the markets will less risk.

In closing, be aware that volatility has returned and is most likely here to stay. This is a good thing because it gives us more opportunities to pick up great values when they are mis-priced by less knowledgeable investors. That is all, now soldier on.

 

Want more data? Download the complete newsletter history (1992 - 2016)

Newsletter Performance

iq trends newsletter performance statistics

Performance data for the Investment Quality Trends model portfolio is compiled and maintained by the Hulbert Financial Digest, an independent third party.

The benchmark index for the Investment Quality Trends model portfolio is the Dow Jones Wilshire 5000 Total Market Index. Since 1986 the Investment Quality Trends model portfolio has demonstrated, on average, approximately 15% less risk than the Dow Jones Wilshire 5000 Total Market Index.

The Lucky 13

Lucky 13 stocks predicted to outperform the market

The Lucky 13 appears in the January issue of the newsletter and shows 13 stocks we think can outperform the market.

In short, The Lucky 13 has been extremely successful and not surprisingly, quite popular. While not every stock in each Lucky 13 portfolio has been a winner, there have been sufficient winners in each group to produce 15 years of positive total returns, twelve of which have exceeded 10%.

The Timely Ten

the timely 10

Whether you are looking to build a portfolio from scratch, are partially invested and looking to add new positions, or are fully invested and merely in need of some affirmation and hand holding, The Timely Ten presents our top ten recommendations as of each issue.

Short of utilizing the personal investment management services of our sister company, IQ Trends Private Client Asset Management, this is as close to real time as you can get.

About the Charts

about the iq trends charts

In each issue, with the exception of the first of the quarter, IQ Trends publishes four of our proprietary charts. These charts range from new entries into the Service, new entries into the Undervalued category or modified Profiles of Dividend Yield, companies in the Timely Ten, or companies that exhibit characteristics that show promise.

As a value added benefit to our subscribers, IQ Trends now allows access our archive of proprietary charts. No longer will subscribers have to wait for their favorite company to fall into one of the above mentioned categories for its chart to be published.