Updates to add details and comment on the Federal Reserve meeting today.

Ten-year U.S. Treasury yields could spike to 3% as soon as February, as concern about U.S. infrastructure spending and the effects President Donald Trump is having on domestic policy erodes the safe-haven qualities of benchmark U.S. debt. This would be disruptive to all markets. 

While this chart of 10-year Treasury yields is extremely simple, it illustrates what a lot of technicians are pointing to, that if 10-year yields break 2.65% from around 2.5% today, there's very little support until they hit roughly 3%:

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There are many reasons why I think there's a real possibility of this sort of break happening, and why I'm particularly nervous about yields on longer-dated Treasuries. Here are some of them. They are:

Central Banks Are Pulling Back Support

The Federal Reserve hiked the fed funds rate in December and is talking about three more hikes this year. The Fed has even started discussing shrinking its balance sheet.

However, it's not just the Fed that's tightening monetary policy. The Bank of England, the Bank of Japan and the European Central Bank have all shown signs of pulling back their bond market purchases.

Less Demand from Foreign Buyers

With oil-exporting countries struggling and Chinese growth slowing, foreign buyers will have less interest in purchasing U.S. Treasuries, even at the best of times. And in the worst of times (as we saw in November), foreigners will actually sell Treasuries.

This lack of foreign demand tends to occur rapidly when other countries' domestic yields rise, and rising yields are typically a global phenomenon.

A Larger Supply

All the spending the Trump administration is discussing is going to need financing, and I expect the U.S. Treasury to increase the issuance of long-dated bonds. I think Treasury officials believe the government should fund long-term projects with long-term debt, and I suspect they're even likely to test 50-year bonds Treasuries.

However, U.S. corporations have been doing a record pace of debt issuance in January, and all that paper will compete with Treasuries for institutional investors' bond money.

Fed Meeting

The Federal Reserve left short-term interest rates unchanged Wednesday as inflation lagged the central bank's goal despite expanding job growth in January.

The benchmark rate will remain at the range of 0.5% to 0.75% set in December after only the second increase since the 2008 financial crisis. While the central bank's monetary policy committee has projected at least three hikes this year, members reiterated that rates are "likely to remain, for some time, below levels that are expected to prevail in the longer run."

The remarks are slightly more dovish than the market was expecting. The statement that "Near-term risks to outlook 'roughly balanced'" is being highlighted by the bond bulls. Confidence that they will hit their inflation target is being touted by the bond bears. As a whole, market participants are underwhelmed by the statement. Expect more from Fed Chair Janet Yellen's Congressional testimony later this month, and if non-farm payroll data tracks today's ADP release - which was extremely strong, look for the market to react poorly.

The initial reaction in the treasury market is to rally a bit, but I suspect this won't last as the initial reaction is often wrong and there is just too much data on the horizon. We also have a lot of treasury issuance next week which could weigh on the bond markets.

Domestic-Policy Risk

U.S. Treasuries and German bunds have historically been safe havens any time that markets experience a "risk-off" moment. But if we get a risk-off moment due to the Trump administration's domestic policies, there's little reason to believe that investors will flock to U.S. Treasuries in the way they have in the past. This is a concern that's only increased recently.

Adding fuel to the potential fire is that risk-parity strategies that rely on bonds to "zig" any time that stocks "zag" have already seen extremely large inflows. There are still many scenarios where investors will want Treasuries in times of stress, but I think that's less of a given.

Bond Investors Are Too Pessimistic

Bond investors tend to be glass-is-half-empty people, and they missed the signs of U.S. growth and inflation in late August and early September.

I think that they're once again missing such signs for the near-term horizon.

Not Everyone Is Shorting Treasuries

I'm hearing story after story about a record number of speculative shorts in Treasury futures contracts, but I think these really overstate the market's positioning.

If players were truly that short on Treasury futures, then we would see signs of this elsewhere. I've searched and searched and am not finding evidence of large short positions away from the futures. For example:

  • The repo market, where investors who are shorting Treasuries go to borrow them, shows no obvious signs of large short positions.
  • ETF flows have been reasonably balanced of late, so they're not pointing to a wholesale bearish positioning in Treasuries.
  • Institutional-investor surveys, including a noteworthy weekly one from JPMorgan, show only small short positions at most.

The Bottom Line

Add it all up and there are many possible explanations for the large short position in Treasury futures. For example, we could be seeing hedges against off-the-run Treasuries for those trying to profit from opportunities there, or even hedges on positions in corporate bonds. Neither of these mean that the market is "net short on rates."

I think it's time to be cautious on Treasuries. I'd suggest pulling back from ETFs like the iShares 20+ Year Treasury Bond ETF TLT and the iShares Barclays 7-10 Year Treasury Bond Fund IEF and moving to shorter-dated maturities.

Regarding other types of bonds:

  • Investment-Grade Corporate Bonds. These are also at risk. While their spread component might do well, many such bond funds' interest-rate risks are large. For example, the iShares iBoxx $ Investment Grade Corporate Bond ETF LQD has four of its top 10 holdings with maturities of more than 20 years. (One of its top holdings even matures in 2054.) I don't think you're being adequately compensated for taking that risk right now.
  • High-Yield Bonds. Interest-rates moves tend to affect these bonds less, so they should outperform other bond classes, especially if we see mergers-and-acquisition activity, which tends to benefit smaller companies.
  • Leveraged Loans. I prefer leveraged loans with floating rates, like the PowerShares Senior Loan ETF However, I view leveraged loans as such a core part of any income portfolio that I would look for leveraged-loan mutual funds, which should outperform in the long term.
  • Muni Bonds. It's probably wise to hold off on municipal-bond purchases, although some closed-end muni funds trade at a large enough discount to NAV that it might be worth dipping your toe into the water.
  • Preferred Stocks. At the other end of the spectrum, preferred stocks should do very poorly in this environment. After all, many preferred stocks have complicated structures that will make any rise in yields very punitive. So, I'd suggest avoiding preferred-stock ETFs like the iShares U.S. Preferred Stock ETF PFF for now in spite of their higher potential yield.

More information on TheStreet's guide to trading in the month of February can be found here:

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