The price of U.S. dollars is perhaps the most important single price in the world. The reserve currency status of the dollar encourages governments, businesses, and consumers worldwide to borrow and transact in dollars as well.
The U.S. Treasury market, as the benchmark for interest rates on longer-dated U.S. dollar debt, is crucial for that reason. This morning, the 10 year yield is hitting its highest level since mid-2011:
Some view this as bullish behavior for risk assets (investors moving out of low-yielding safe Treasuries and into riskier assets) while others view this as bearish behavior for risk assets (higher interest rates is a tightening of financial conditions).
While I don’t think it’s so cut and dry for either side, I do see a few sector specific implications if 10 year yields remain above 3% in 2013. Back in mid-September, my Macro Wrap post detailed some of the knee-jerk reactions to the Fed’s non-tapering announcement:
While interest-rate sensitive sectors were some of the strongest performers on yesterday’s bounce (most notably, REITs and housing-related stocks), the plain fact of the matter is that rates are much higher than they were 3-6 months ago. While the Fed would like to see long-term U.S. rates go lower, other asset classes and geographies are reacting much more violently to the central bank.
If that rate stickiness continues (regardless of whether the taper comes in Oct, Dec, or 2014), my hunch is that the rotation that we saw yesterday is more likely to reverse. Financials and health care will once again attract funds and outperform. Emerging markets and U.S. real estate-based investments will resume their descent. Beware the rate sensitive head fake if rates don’t actually comply.
Fast forward 3 months, and the rate sensitive areas of the market have indeed underperformed. In fact, the KRE/IYR spread trade that I outlined later that day has been a huge winner over the past 3 months as rates have climbed higher. Here is the KRE/IYR ratio, with the post-September FOMC reaction circled in green:
Of course, at this point, some of these relationships have been pushed quite a bit (regional banks have outperformed REITs by almost 40% in the past 7 months). However, if the rate trend continues higher, the potential dispersion among market themes could continue into 2014.