In this article, I want to explain why I believe that government bond (TLT) yields will rise again after hitting new lows last week.
I am not breaking any news when I say the USD has performed rather poorly over the last few months. The world’s most important currency has been crushed by risk-on capital flows into emerging markets and rate hike expectations from several major central banks.
^DXY data by YCharts
One thing that happens when the USD is weak is that commodities have room to accelerate. A weaker USD means USD-denominated commodities become relatively cheaper. This benefits commodity-intensive emerging markets, both because commodities are cheaper and because of the lower USD debt load.
The next graph shows you the result of a falling USD. Chinese producer prices are accelerating rapidly.
(Source: Bear Traps Report)
Producer prices had already accelerated going into the commodity bottom of the first quarter of 2016 and started to explode once the USD showed weakness.
In addition to that, you find the most important industrial commodities in the graph below.
JJC data by YCharts
There is no denying that inflation pressure is building up. Especially because China is going to export inflation over the next few months, which will likely surprise the Fed.
Today, as the Fed has dramatically softened the rate hike outlook – the dollar plunged and the global economy is picking up steam. In the months ahead, it will be pure entertainment – watching the Fed try and deal with this global economic feedback loop back yet again.
– Bear Traps Report
Bonds, What Are You Doing?
Right now, it looks like bonds are either fully ignoring inflation risks or they don’t believe it.
One interesting comparison can be seen below. Bonds (green line, inverted) are rapidly soaring after plunging in the third quarter of 2016. Copper (black line), on the other hand, is accelerating to the highest levels since early 2014.
Even when we look at the rate hike probabilities, we see that the first hike is likely to be in June 2018. The highest probability is 55.3%, which is in September 2018.
(Source: Hedge Fund Telemetry)
The next graph displays the correlation between bonds and inflation even better. Every inflation uptrend has been followed by higher bond yields.
However, this time it looks like we are in a serious inflation uptrend. Price growth bottomed in 2015, and has climbed higher with multiple higher bottoms. Bond yields, on the other hand, keep trading like they did between 2010 and 2016.
Bond yields have fallen over the past few months. Investors and traders are ignoring growth acceleration and inflation pressure, and do not expect the Fed to hike until June 2018.
We are likely going to get a scenario where traders need to reposition themselves to avoid getting hurt once the Fed has to act. I strongly believe inflation (all items) might hit 2.5% over the next few months. Bond yields could likely surge back to post-election levels (2016 at 2.5%).
The best way to play this is by buying banks (KBE) or regional banks (KRE). Both are major winners in an environment of higher economic growth and higher bond rates.
Many thanks for reading my article. Feel free to leave a comment if you have questions or remarks.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article serves the sole purpose of adding value to the research process. Always take care of your own risk management and asset allocation.