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Treasury yields positioned to rise

03/13/2012

On January 1, 2012, Greg Zuckerman penned an article for the Wall Street Journal that shared market insights for the upcoming year from Tobias Levkovich, Citigroup's chief U.S. equity strategist, James Paulsen, chief investment strategist at Wells Capital Management, and me. 
 
Here are my two quotes from the article:
 
“During the second half of the year, "I expect a historic reallocation trade out of safe-haven Treasurys into risk assets" such as stocks, says Joe Terranova, author of "Buy High, Sell Higher" and chief market strategist for Virtus Investment Partners.”
 
"In this new climate of European debt concerns, I haven't heard anyone suggest shorting Treasurys," says Mr. Terranova, a sign of an end of the bull market. He, however, is anticipating a selloff of Treasurys that "will be a once-in-a-generation" investment opportunity.
 
It is time to update those expectations and highlight my belief that current evidence suggests that those owning Treasuries should be conducting an analysis to determine if continuing to own Treasuries (Figure 1.1) is the correct investment.
 
Let me reiterate, I expect a historic unwind, or sell-off, in both U.S. Treasuries and the German Bund, both of which have been safe harbor trades for most of 2011.
 
Throughout much of 2008, the “real interest rate,” in this case defined as the 10-year U.S. Treasury versus CPI (Figure 1.2), traded in negative territory. That price action was fueled by a “hot” CPI above 4%. In the middle of 2011, the relationship (Figure 1.3) once again moved into negative territory, this time on historically low Treasury yields.  What I expect is currently underway is that the softening in precious metal prices (Figure 1.4) is telegraphing a move back into positive territory for the “real interest rate” relationship.
 
With inflation concerns under control, the catalyst for the move back into positive territory will be driven by rising Treasury yields. While rising gas prices in the media headlines will stoke inflation fears, please note that wages remain stable and soft commodity costs are falling. Continued improvement in U.S. economic data should reverse any false expectations that further easing by the FOMC is imminent. I expect it is not. QE3 would be an unfavorable condition for risk assets and signal an equity market correction. Not happening.
 
Hopefully, for those of you reading this blog and hiding in Treasuries, you will at least roll up your sleeves and determine if staying in Treasuries is the favorable investment. I expect it is not.

Figure 1.1 U.S. 10-Year Treasury, April 2007 to Present

Source: Bloomberg
 
Figure 1.2 CPI, April 2006 to Present

Source: Bloomberg
 
 Figure 1.3 2007 to Present, Relationship between CPI and 10-Year Treasury Yields

Source: Bloomberg
 
Figure 1.4 Spot Gold Prices, March 15, 2011 to Present

Source: Bloomberg

Virtus Investment Partners provides this communication as a matter of general information. The opinions stated herein are those of the author and not necessarily the opinions of Virtus, its affiliates or its subadvisers. Portfolio managers at Virtus make investment decisions in accordance with specific client guidelines and restrictions. As a result, client accounts may differ in strategy and composition from the information presented herein. Any facts and statistics quoted are from sources believed to be reliable, but they may be incomplete or condensed and we do not guarantee their accuracy. This communication is not an offer or solicitation to purchase or sell any security, and it is not a research report. Individuals should consult with a qualified financial professional before making any investment decisions.