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Interest Rates Are Heading Higher, But Don’t Expect It To Last

By Michael KramerJun 14, 2019 02:07AM ET
www.investing.com/analysis/interest-rates-are-heading-higher-but-dont-expect-it-to-last-200431170
Interest Rates Are Heading Higher, But Don’t Expect It To Last
By Michael Kramer   |  Jun 14, 2019 02:07AM ET
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This post was written exclusively for Investing.com.

Call it a dead cat bounce if you want, but interest rates on the 10-year U.S. Treasury are likely heading higher—perhaps to as high as 2.42%—for a little while, at least. Currently, bonds appear to be overvalued versus equities by a wide margin when comparing the 10-year yield to the S&P 500 dividend yield.

But we don't think rates are going to head back to 3%—it's very unlikely that would happen. Especially with the type of inflation data that keeps rolling in and the plunging rates in Europe. Indeed, there's a good chance that after a slight increase in yields, rates on the 10-year will plunge below 2%.

Technical Bounce

The technical chart shows that the yield on the 10-year has bottomed out for the time being and is likely to reverse and head higher. Currently, the yield is attempting to rise back over a technical resistance level at around 2.13%. Should it be successful, the next major level of resistance would not come until 2.31%.

The chart also shows that those yields have been falling in a well-defined trading channel, and depending on how quickly they rise; yields could increase to the upper end of that channel at roughly 2.42% followed by a resumption of the downtrend. The relative strength index is also suggesting that yields have fallen too far. The RSI fell to approximately 20 on June 4. A decline below a level of 30 is considered to be oversold.

UST 10-Year Daily Chart
UST 10-Year Daily Chart

All charts powered by TradingView

Another way to consider that bond yields may be poised to rise is to measure the 10-year yield versus the S&P 500 dividend yield, creating a ratio. Currently, the ratio stands at roughly 1.1, with the 10-year at 2.1% on June 13, and the S&P 500 dividend yield at approximately 1.90%. This ratio can be calculated by dividing the 10-year yield by the S&P 500 dividend yield. The chart below shows us historically that bonds are likely overvalued to stocks at the moment.

U.S. Treasurys To S&P 500 Yield Ratio
U.S. Treasurys To S&P 500 Yield Ratio

One can determine that bonds are overvalued to stocks using a historical perspective. For example, in the late 1990s, the chart shows that the ratio reached a very high level when the equity market was in its bubble phase, suggesting that equities were very expensive compared to bonds.

Contrast that with 2008 and 2009, when stocks were plummeting, and bonds saw a flight to safety, suggesting that bonds became overvalued to equities. With the ratio currently pretty close to the lower end of the range, it would suggest that bonds are overvalued to stocks, or that stocks are very cheap when compared to bonds. Given the recent decline in rates, it seems more likely that bonds are overvalued to equities at this point.

Inflation Rates Are Falling

If bond yields do rise, don’t expect it to last, because the inflation rate in the U.S. continues to fall. The consumer price index increased by 1.8% year-over-year in May, down from 2.0% in April, and down from 2.5% a year ago. The producer price index was also up 1.8% year-over-year in May, and it too was down from 2.2% in April and 2.6% last year.

Inflation Rates
Inflation Rates

Spreads Are Contracting

It isn’t just the low inflation rates; yields on the German 10-year Bund are now at -0.24%, their lowest levels ever. The low yields in Europe could help to drag U.S. yields down too. The spread between the U.S. and German 10-year notes are still very wide and in the process of contracting.

Should that spread contract further it could result in the U.S. yield falling over time. Should the spread contract below 2% wide from its current—roughly—2.35%, and German bund yields not rise, the U.S. 10-year could fall to as low as 1.8%.

UST 10-yr DE 10-yr Spread Weekly Chart
UST 10-yr DE 10-yr Spread Weekly Chart

For now, bond yields are likely to catch a bounce over the short-term; after all, nothing ever goes down in a straight line. Should rates rise, it is likely to signal nothing more than the fact that yields simply fell too far too fast. Just keep in mind what may be coming next, even lower rates.

Interest Rates Are Heading Higher, But Don’t Expect It To Last
 
Interest Rates Are Heading Higher, But Don’t Expect It To Last

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Tommy TS
Tommy TS Jun 14, 2019 10:16AM ET
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strategy= Long yield, short equities
Aaron Roberts
Aaron Roberts Jun 14, 2019 10:00AM ET
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Your article assumes the equities market is going to remain stable. If equities start falling then bonds can and will continue to be oversold for a long period of time. Even the recent rally in the indexes didn't produce much relief on the bond yields. One could argue that until the fundamental data returns to support the risk in the equities markets bond yields could stay low or even go lower from here.
Ashish Prasad
Ashish Prasad Jun 14, 2019 9:53AM ET
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These long term charts might be correct, but one or two months of delay may well be a noise on a long term chart. Given the falling inflation expectations, its difficult to see how rates may go higher right now. Sentiment needs to improve somehow for such move to happen.
Hei Leopold
Hei Leopold Jun 14, 2019 9:50AM ET
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you could also argue that the dividend yield is way too high versus bonds and will sink in the next months. than the equation will be fine again.
Ryan Skuse
Ryan Skuse Jun 14, 2019 9:46AM ET
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Oh but itvwill last as long as bonds continue to sell off. Natural yeild increases will overcome bench rate
jim boblooch
jim boblooch Jun 14, 2019 8:25AM ET
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thanks
 
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