Surging Bond Yields 2018’s Twist

It took more than a year to happen, but interest rates are finally rising again. On Monday, the U.S. 10-year Treasury yield leapt to as much as 2.73%, the loftiest level in nearly three years and decisively above of last year's high of 2.64%.

In turn, bond ETFs tied to the 10-year, such as the iShares 7-10 Year Treasury Bond ETF (IEF), tumbled (bond prices and yields move inversely). IEF is down 2% this year, while the broader iShares Core U.S. Aggregate Bond ETF (AGG), which holds Treasuries and other investment-grade bonds, is down 1%.

US 10-Year Treasury Yield

10-Year Outpacing 2-Year

The latest jump in interest rates was in many ways expected. Since the 10-year Treasury yield's previous peak in December 2016, the Federal Reserve hiked interest rates four times, and by 1 full percentage point; stocks surged by more than 25%; and the unemployment rate hit an 18-year low―all factors that typically put upward pressure on yields.

Short-term interest rates have been responding to these cues; long-term rates are just starting to pay attention. The two-year Treasury yield increased by 0.67% in 2017, at the same time that the 10-year yield fell by 0.04%. This year, the 10-year yield is outpacing the two-year yield with a gain of 0.30% compared with 0.24%.

Brian Jacobsen, chief portfolio strategist at Wells Fargo Funds Management, says that, up until now, the long end of the curve was being suppressed by geopolitical fears, especially related to North Korea.

"The apparent détente with South Korea has helped push yields higher," he said. "The market narrative has also shifted toward answering when—rather than whether—the ECB and Bank of Japan will start to let the long end of their curves move higher."

Yield Curve 'Spring Loaded'

Now that rates are moving up, it's natural to ask, how high can they go? A consensus of 64 Wall Street analysts compiled by Bloomberg sees the 10-year yield reaching 2.86% and the two-year yield reaching 2.41% in the fourth quarter.

Jacobsen, who believes the Fed will hike another two or three times this year, sees little resistance to the 10-year yield getting to 3%, but doesn't envision it reaching 4% in 2018. He also sees the long end of the curve moving up faster than the short end.

"We think the yield curve could be spring-loaded. It’s compressed with the short end moving up and long end staying low. Rather than signaling an economic slowdown, we think it could aggressively steepen," he said.

0.75% Increase Per Year

Taking a somewhat more aggressive view on rates is Jeffrey Gundlach. Speaking on his latest webcast, the CEO of DoubleLine Capital predicted that the 10-year Treasury yield could slowly advance to 5% or 6% by the next presidential election in 2020 as the Fed hikes, Treasuries roll off the central bank's balance sheet ("quantitative tightening"), and as government debt as a percentage of GDP increases.

"I don't think it's at all strange to think we can tack on something like 75 basis points―on average per year―for the next four years or so," he said.

A gain of 0.75% this year would take the 10-year yield to 3.15%.

Like Jacobsen, Gundlach agrees that monetary policy in Europe is something to watch. If the ECB takes a more hawkish stance and allows German yields to find their real level, they would "quickly move up" and would "un-anchor the U.S. 10-year interest rate, which is undoubtedly being held down on a relative value basis," Gundlach remarked.

What Investors Should Do

With the path of least resistance for rates being higher, investors may have to take action to maintain the desired risk and reward characteristics of their portfolios.

Gundlach recommends that investors gravitate toward shorter duration bond funds. "You don't want to be in a standard index fund with a duration of 6," he said. "You don't want to be in a corporate bond fund" while interest rates are rising, he warned.

Echoing that advice, Wells Fargo's Jacobsen said his firm has been positioning for an abrupt adjustment in yields by keeping durations shorter, and in some cases, shorting Treasury futures.

He added his income-orientated portfolios are diversified both geographically and in terms of asset class. Jacobsen says that looking at portfolios through the lens of macroeconomic sensitivities to growth, inflation and rates can help illuminate where the better opportunities are.

"Not every income-oriented investment has to carry with it a lot of interest rate risk,” he noted. “High yield bonds are more sensitive to growth than to rates. REITs can be hurt in the short term by a move up in yields, but provided they are decent cash-flow-generating investments, those losses can reverse."

"Higher-yielding global equities can give you exposure to growth without a lot of adverse exposure to moves up in Treasury yields,” Jacobsen added. “For inflation protection, short-term high yield can be more attractive than TIPS, as TIPS are still at their core long-duration Treasuries."

Sumit Roy can be reached at [email protected]. Follow him on Twitter @sumitroy2.