The bond market has long needed a chiropractor. It is “misaligned” from its usual upward trend since July 2022. And according to a closely followed indicator on Wall Street, that means we should have a recession will begin next July.
But employment is strong, inflation is moderating and the stock market is at all-time highs. These are the boilerplate “bull” arguments. The “bears” oppose the unsustainable levels of credit card debt reached by American consumers and the unsustainable budget deficits supported by the US Congress. Oh, and it's an election year.
Frankly, none of this matters to me, and it probably shouldn't to many investors. We can't control what the market does, but we can control how we position ourselves accordingly. And on October 1 last year I wrote an article which has drawn attention to a potentially rare opportunity to acquire some of the less risky bonds or bond ETFs, including the 2-year US Treasury Note ETF (NASDAQ:UTWO) and generate not only a good income, but perhaps even capital gains. This part of the bond market is known for its stability and, more recently, for its relatively high yields compared to the last 15 years. But no price appreciation.
This 1-2 punch: yield plus price appreciation, from a rare source
It turned out that UTWO and other short- and medium-term U.S. Treasury ETFs actually delivered this potential “1-2 punch” of return and appreciation. The capital gain was modest, but that's about all it could be unless rates move back toward zero.
And while that could still happen, I point out that four months after that strong buy call from UTWO, it's simply a good hold for me now, in the traditional sense. That is to say, I like the income, but the capital gains that contribute to that return are not as juicy as they used to be. This has more to do with bond market indecision than anything else.
Above is the current situation regarding the 10-2 spread. It stands at 33 basis points, which is a step away from a re-inversion of the yield curve. This could mean that 2-year rates and UTWO will rise in yield and price, but I'm not counting on that. I want to stay “in the game” for this scenario, but too many other things are vying for my attention and assets, including the YARP stocks I've written about and a potential (emphasis on “potential”) 2000 – as a rise in a small number of Nasdaq 100 stocks.
Below is a chart of the U.S. Treasury yield curve at three recent points in time. Blue is from last Friday, red is from four months ago, and green is from 12 months ago. What happened? For 2-year rates, almost nothing over 12 months, but over the last four months they have fallen by more than 60 basis points. This generated the UTWO total return I was looking for.
Meanwhile, the very short end of the curve (Treasuries) still yields a ton, but the critical 10-year end is at 4.0% compared to 4.3% for the 2-year security. What happens next? I don't know, but over time I would expect the 2 year yield to decline, not fall. I just see too much tugging in the bond market right now, and the Fed is confusing everyone with their rhetoric.
The 10-year rate suggests a slight rise, and so (just an estimate) I could see something like a 3.9% rate over 2 years and a rate of 4.0% over 10 years, and bang! here is our inversion of the inversion. And the headlines will scream “recession”. That's why I'm happy to let prices be the guide and not make a living predicting rates and recessions!
UTWO: Owns 2-year US Treasuries, got the job done, but the 'moment' may be over
UTWO delivered its results during the brief period I wanted to capitalize on. This 2.83% return over four months corresponds to an annualized return of approximately 8.5%. Not bad for 2-year US Treasury bonds! But the key thing is that purple line, which shows that UTWO gained 1.2% over the 4-month period. That may not sound like much, but it equates to a 30% gain in the S&P 500 in four months. In other words, it happens but rarely.
So the UTWO window of opportunity, while still open, is something I'm less excited about. I continue to maintain a position in the 2-year US Treasury, but primarily through real bonds. I still hold a modest UTWO position, but as noted above, it is now more of a hold than a strong buy. It was worth it, and the results certainly generated some alpha compared to Treasuries alone, but it's time to make room for other, more attractive reward/risk tradeoffs in my portfolio.