We are witnessing surprising strength in US interest rates as US government bond yields jumped across the curve to the highest level since early June. The closely watched 10-year bond rate is now at 0.82% as of October 21, and the 30-year is at 1.62%; up from 0.53% and 1.21% respectively in early June. This is a reversal of sentiment for bonds (bond prices fall as interest rates rise and vice versa) an asset class that has been one of the top investment success stories for 2020. The US 20+ Year Treasury ETF (TLT) delivered a 35.0% gain in 2020, as interest rates dropped sharply in the first half of 2020.
Few individual investors actually invest in US government bonds, so the real concern for everyone is not so much falling bond prices, but the impact rising interest rates may have for the equity market. Rising interest rates, in combination with a weakening US dollar and widening credit spreads (the premium that US companies have to pay for investors to buy their bonds) could challenge the strength of US equity markets. Equity prices will fall if higher interest rates sustain or credit spreads widen further. For now, that seems a little unlikely, since that would mean a complete disregard for the US Central Bank’s clearly stated goal of rates being “lower for longer”. Within that framework of fundamentally lower interest rates, a spike in rates, even a sustained one must be taken in the right context; bond yields spiking so close to a US presidential election is not uncommon.
The expectation for this election cycle is that Democrats are likely to retain the House of Representatives and take the Presidency. Usually, a party in full control means the ability to increase government spending. Increased spending forces the government to borrow more money which leads to a jump in interest rates. Increase in borrowing rates for any government also means increased borrowing costs for companies (widening of credit spreads) and a general increase in cost of borrowing for the economy as a whole. The combination of USD weakening, credit spreads widening and rising interest rates could be more likely indicating the end of the outperformance of US large cap equities relative to emerging market stocks and domestic cyclical and value stocks, rather than an end to the bull market per se. So, effectively, we see a reallocation of capital to the more cyclical, industrial and commodity-linked sectors of the economy (think of ETFs like XME and XLI that track the material and industrial sectors).
Investing in US banks should be the obvious (though cautious and gradual) buy trade with rising yields, despite the risk of rates remaining lower in a historical context. For the more adventurous at heart there is another way to play the current development in interest rate markets: buying the Proshares short 20+ year treasury ETF (TBF). This is an inverse ETF that works as the opposite to the TLT, producing the highest returns in case of further or sustained increases in treasury yields and consequent fall in bond prices.