Lesson 3: The 10 Year Treasury Bond

1 month left in the year people. Let’s make it count.

In Lesson 1, we looked at inflation, and why it’s likely to be here awhile.

In Lesson 2, we talked about ‘Higher for Longer’, the Fed’s response to said inflation.

In Lesson 3 today, we’re going to talk about the 10 Year Treasury Bond and why it’s the benchmark for so many things from a macroeconomic perspective.

Why the 10 Year Treasury Bond Matters

The US Treasury run by Janet Yellen (yikes! 😱) has a variety of tools to handle the finances of the country. The primary one is the ability to issue debt (Treasury Bonds) to finance the government's budget and operations when we run a deficit (we spend more than the revenues (taxes) we take in). 

I hate using the word revenues because it implies the government is a business that 'makes money' and is a productive economic engine when it isn't. The only real money the government takes in is from taxes from you and me under the threat of violence (pay it or we'll throw you in jail).

First, you should understand that if the government was a person, they'd have a credit score of around 500. The government has racked up huge deficits (annual expenditures greater than taxes) and monstrous long term debt of $34 Trillion (the sum of all it's annual deficits that we have to pay back). This number doesn't include the 'unfunded liabilities' we have as well to things like future social security and Medicare payments which are approximately another $120 Trillion. Needless to say, the debt is something we can likely NEVER pay back.

People who loan money to the government (aka bond investors) have slowly come to the realization that there is no viable way to cut spending or pay back our entire debt. Therefore, between this realization and inflation which continues to run hot at 4%, investors are demanding a higher return on the money they are willing to loan the US government (Treasury bonds).

The government previously could borrow money at a 1.5% rate. That rate (along with inflation and spending) has ratcheted higher in the recent months in light of the above. The 10yr Treasury is now priced at about 4.50% and realistically, could trade back to 5% or above.

This has two major impacts.

One, it makes the cost of running the government more expensive.

Borrowing $1 Trillion at 1.5% is a lot less expensive than borrowing at 5%. The interest expense alone is about $350B more per year. That $350B increases our deficit, and chews up more of our discretionary spending. Instead of spending more on the military, infrastructure or other items, we must pay higher interest expense. Think of it like paying off the minimum balance on your credit cards. As the total principal owed goes higher and the interest rate on the credit cards march higher, that minimum payment can double or triple.  Which ties into our next point.

At a 5% Ten year Treasury bond, borrowing is more expensive for everyone. The 10 year is a benchmark rate and people use it to set borrowing rates for individuals (mortgages, credit cards, auto loans), businesses (high yield debt to finance business borrowing), and governments (see example above why it's more costly to finance govt operations and deficits).

When interest rates are high, everything is more expensive. Simply put, when individuals, businesses and governments have to borrow at 5.5% vs 1.5%, money is more expensive.

Mortgage rates are a good example. Many people locked in a 30 year fixed rate mortgages at 3% or less. The current 30yr is close to 8%. If I bought a $1,000,000 house and financed it entirely at 3% (borrowed the $1M), my monthly payment would be $4000 before insurance and taxes. At 8%, the monthly payment is $7500 - almost double. High interest rates make money more expensive.

This has the practical effect of slowing the economy. When borrowing is expensive, people buy fewer and less expensive homes, cars and spend less on consumer goods (eat out less, fewer movies, etc). Consumer spending is approximately 70% of the US GDP (Gross Domestic Product - the metric we use to measure the output and health of the economy).

For subscribers to my Sovereign Sunday letter, I flagged some serious issues with the 10 year bond moving higher back in September that are still applicable today.

Here are a few other reasons that the 10 Year is likely going to stay elevated compared to the levels we’ve seen over the last 20 years:

• Skyrocketing national debt, now at $33 trillion

• A flood of government bonds in the market – billion issued every week

• Foreign bondholders, like China, are selling their bonds – not BUYING

• The real impact of quantitative tightening is yet to hit

• Outsourcing production to China no longer deflationary

• Workers and unions are gaining power, leading to more strikes and wage increases

• The Peace Dividend is fading. This refers to reducing defense spending and using the amount for other public purposes.

• Energy costs are surging.

• Biden’s failure to refill the Strategic Petroleum Reserve is a dangerous mistake.

• Higher gas prices will boost inflation expectations.

• The shift to electric vehicles and Net Zero will be"Incalculably expensive”

Takeaway: We enjoyed uncommonly low interest rates for 15 years. Higher rates are here to stay and they will slow economic growth. Rates should bounce between 3.75 and 5.5.  When the recession hits for real, rates should come down from the 5% level as investors typically 'flee to safety' and buy bonds. 

Key Lesson: Bond prices move inverse to their rates. So when rates go up, bond prices go down and vice versa. Higher interest rates means money is more expensive and that slows economic activity.

Alpha360 Advice

I'll give the same advice here that I gave in our Alpha360 live coaching group back at the beginning of the year.

1. Inflation is not going back to 2%

2. The 10yr is going to stay elevated compared to recent levels.

3. The 10yr is a ‘value trap’. 5% 'risk free' is a phenomenal rate of return. However, with inflation sticky around 3-4%, you're really only getting 1.5% of ‘real’ return. And with the debt spiral we are in, eventually the Fed will be forced to cut and finance the debt itself (print money to buy the bonds the Treasury is selling to finance the government budget). That means more printing, more dollars in circulation and further dollar devaluation.

   
   We saw this occur during the pandemic. 40% of all dollars in circulation were printed during that time. It's one of the chief reasons we saw inflation explode. It will happen again to some degree if the Fed is financing the US deficit (printing money to buy bonds aka as 'monetizing the debt'). That means the dollars you will get paid back in 10 years from now if you lend it to the government will be worth a lot less than the ones you lent to the government when you bought their 10yr bonds.

   
   Take a look at McDonald’s value meals. If you invested $1000 15 years ago in US bonds, you got back $1000 (plus about $300 in interest). That $1000 could buy approximately 200 value meals at $5 a pop.

4. McDonald’s value meals are now $8. So the $1000 you got back can only buy you 125 Value Meals - 75 less meals! Your money is simply worth less. At this rate, in 10 years a McDonalds value meal will probably be $15 or $20. So you'll only be able to buy 50 value meals. You're money will be worth much less so you'll actually be getting a very small or negative rate of return for investing in 10 year bonds at 5%.

5. Short term treasuries is a better bet. Investing in the 2yr bond at a 5% coupon (you get paid $50 a year on a $1000 bond), you only have dollar devaluation risk for 2 years or less, not 10.

6. I don’t think market indices will move substantially higher for 5 years unless the Fed turns on the faucet and prints like crazy. When the Fed prints, assets go higher - stocks, real estate,  etc. That’s great if you own capital assets. The only problem is the dollar is worth less so the goods you want to buy with your new wealth is also much more expensive.

   That's why if you price the S&P 500 market index in gold, it's trading at about the same level as it was 25 years ago. Gold is considered 'hard money', meaning it doesn't lose its value like the dollar and it's a lot harder to devalue. If the stock market is up 50% and everything you need to buy is up 100%, you didn’t get richer, you got poorer.

7. Oil and energy is a BIG problem. Between the climate change lunacy, ESG and Biden’s hostility to drilling and development, we’ve got a real issue with our core energy needs that can’t be made up with ‘alternative’ energy.

   We flagged this market disconnect at $65 oil in the Alpha 360 group in the Spring. Now, OPEC has predicted a shortage of up to 3 million barrels daily for the last quarter. With steady demand in the US, China and India, oil traded up to $100 in early Fall even with a strong dollar and concerns about high global interest rates.

   After we come out of the recession that I expect in 1st and 2ndQ of 2024, oil is heading to $150 and higher absent significant US & global policy changes.

Takeaway: Keep an eye on the 10 Year Treasury Bond. It’s a key benchmark and affects mortgages and nearly all forms of government or personal borrowing.