ETF Focus Rewind: Treasuries & High Yield Bonds Signaling Bearishness

With spreads expanding, it could be an early sign that bond investors are turning defensive.

Aug 09, 2021

2 ETFs To Consider Buying (And 1 To Avoid) This Week

The July nonfarm payroll erased some investor fears that the recovery was slowing. GDP growth rates are still healthy, but labor market slack is the one thing that has still been a problem. We know that the Fed is using the unemployment rate as one of its primary benchmarks for economic health, so seeing the rate dive from 5.9% in June to 5.4% in July, its lowest mark since March 2020's reading of 4.4%, helps ensure that labor supply/demand is coming back into balance.

The one thing we didn't see change was the market's expectation that the Fed won't consider raising interest rates until late 2022 at the earliest, according to the Fed Funds futures market. For equities, that was good news, but Treasury yields spiked. Gold also sold off, so there was a definite pivot away from defensive positioning and towards risk assets.

I've been cautious about the direction of the markets even though the S&P 500 and Nasdaq 100 were still hitting new highs, but big improvement in the labor market does calm some of those fears. If the economy continues to show progress in terms of both GDP growth and a lower unemployment rate while the Fed keeps conditions loose, there's a path for higher stock prices throughout the remainder of 2021.

There's two potential headwinds, however, before that narrative plays out - inflation and the government's resolution to the debt ceiling battle. We'll know more about the former when the latest July number is released on Wednesday. Expectations are for a slight tick down to 5.3%, but a reading below that could really go a long way in confirming that Fed's "transitory" narrative and be a real catalyst to send share prices higher.

With that being said, here are three ETFs I'm going to be watching this week and the narratives that go along with them.

Direxion Work From Home ETF (WFH)

The delta variant has become a real wild card for both the economy and the world in general. Even though daily case counts are soaring, it doesn't look like we're facing significant business closures in the same way we did in 2020. In fact, it doesn't look like it's on the table at all. That's good for the health of the U.S. economy, but it's looking like the return of the online economy and the work from home trend is imminent. Many companies are planning on extending the ability to work remotely for the foreseeable future until the delta variant (and any subsequent variants) have subsided.

WFH is one of the best ways to play this trend, which focuses on cloud technologies, cybersecurity, online project & document management and remote communications. In other words, all of the areas that will see strong demand from the work from home trend. WFH has outperformed the S&P 500 by about 6% over the past three months, so there's already some interest in this as an investment trend, but I feel there's some more upside to be had here.

iShares Core U.S. REIT ETF (USRT)

REITs have been one of the market's strongest performing sectors in 2021, but the group is facing an uncertain future. The residential housing market is still strong, but it appears that peak growth has now passed despite the continuation of ultra-low rates. If the delta variant of the coronavirus continues to spread, it could severely impact the business prospects of retail establishments, shopping malls, office buildings and anything else that could experience a drop-off in foot traffic.

USRT has a relatively heavy allocation in commercial REITs, so it's potentially exposed to some extra risk in the current environment. On the other hand, the 35% combined allocation to specialized and healthcare REITs could enjoy some relatively durable demand and the 14% allocation to industrial REITs could benefit the new trillion dollar infrastructure package. The 2.4% yield won't necessarily get income seekers excited, but the overall build of the portfolio still has some potential.

Invesco KBW Bank ETF (KBWB)

The financials sector has been highly dependent on the direction of interest rates and nearly nothing else. As interest rates have fallen, financial and bank stocks have steadily underperformed and vice versa. Last week, the financial sector got a boost from last week's spike in interest rates, gaining more than 3.5%, while bank stocks rose more than 4%. While the prospects for the financial sector may look a little more positive today than it did a week ago, it still all depends on interest rates.

That's where I'm a little less optimistic. We've seen these "micro spikes" in interest rates on multiple occasions since the March peak only to see them re-establish new lows shortly thereafter. Maybe there's some more strength in last week's move since it was a result of unexpected strength in the labor market, but I still believe that the 10-year yield is moving back towards 1%. The debt ceiling fight could be the catalyst or the effects of the $30 trillion of existing debt, but this has the look of just a temporary jump in interest rates. That means financial stocks could very well be heading right back down again.

Chart of the Week

The fixed income market is flashing a few warning signs here. Equities have been moving higher and could very well continue to do so following last week’s strong jobs report. Treasuries and high yield bonds, however, are suggesting that bond investors are remaining more defensive.

The top half of this chart is the 10-year Treasury yield. After dipping as low as 1.13% on Wednesday, the rate pushed all the way back up to around 1.3% as of Friday’s close. Most of that rise came on Friday and the first reaction by many is whether this is the long-awaited trigger that finally ignites a sustained move higher. After all, there are very few signs at this point that the recovery is in full swing.

I don’t think so.

I maintain that the 10-year is still going to move down to 1% before it gets back up to 2%. The flood of liquidity, the Congressional debt ceiling debate and a potential deflationary pulse are still going to put pressure on Treasury yields. You can see above that despite last week’s yield spike, the overall downtrend is still in place. I think the 10-year needs to make a move above the 1.4% level before we can start talking about a trend reversal. With no Treasuries being issued at the moment, there’s a bit of a supply/demand imbalance, but Treasuries might turn toxic if we get into September and there’s no resolution for the debt ceiling.

High yield bond spreads might be offering a more firm signal. We know junk bonds are offering record low yields and spreads are next to nothing. Over the past month, that’s starting to change as bond investors turn more risk-averse. A 3.4% high yield spread is still incredibly low, but that’s about 40 basis points higher than it was several weeks ago. Investors are showing an unhealthy willingness to reach way out on the risk spectrum for a little extra yield and the time may be coming where they’re going to get burned.

Questions, Ideas, Thoughts?

Feel free to reach out by replying to this e-mail or commenting below. Your question or idea might be used in a future newsletter!