Treasuries Flashing Red but Will Equities Take Notice?

Wednesday's Treasury auction went poorly following lower-than-expected demand on the $34B five-year note issuance. The auction pushed the yield on these notes up to 1.85%, roughly five basis points higher than forecast. The 10-year note also rose eight basis points as the Treasury plans to sell a record of $98B in notes this week alone.

News of the auction sent equity markets tumbling mid-day as the DOW shed 300 points off of its morning high before rebounding in the last hour to close up 90 points. Putting the market's roller coaster ride aside, Wednesday's auction is significant because the days of cheap borrowing by the government may be nearing an end. As Treasury supply continues to flood the market, investors will demand higher yields to compensate for potential inflation and increased risk. The panic over the past six months has buoyed the Treasury market as investors fled to the perceived safety of government bonds. This trade will unwind as risk appetite returns, significantly increasing yields. Now I'm not saying that Treasuries are going to collapse overnight, but yields will not remain at these low levels indefinitely.

The US Dollar Index is up 25% over the past year and 3% year-to-date despite the most recent sell-off. This trend is not at all surprising given the weakness that is spreading throughout the Euro-Zone and Great Britain, two regions that are in worse shape than the U.S. The European banks are even more levered than their American counterparts, making the U.S. more stable at this time. However, gold has remained solidly over $900/oz as investors shun paper currencies for the safety of gold. The point, keep a close eye on gold and commodity prices to accurately gauge the strength of the dollar. Reviewing the dollar index trends is akin to comparing bad apples to more bad apples and will not really tell you much.

In order to profit from rising yields, please consider TBT, a double inverse exchange trade fund that moves in the opposite direction of Treasury prices. Normally, I like to stay away from levered ETFs because of a natural time decay, but there are plenty of instruments available to protect investors against rising yields. Current Treasury prices continue to price in a deflationary environment over the next several years. However, the near-term risk is hyper-inflation and much higher yields given the devaluation of the dollar.