After having suffered from an above 25% downside during the last year, both SPDR Portfolio Long Term Treasury ETF (NYSEARCA:SPTL) and the iShares 20+ Year Treasury Bond ETF (NASDAQ:TLT) have delivered gains exceeding 3% during the last five days as shown in the chart below.

Well, this period, even if a rather short one, has coincided with a lot of market volatility following news about the failure of Silicon Valley Bank Financial (SIVB), which is engaged in the financing of startups.

Now, fears of systemic and geopolitical risks are good for treasuries, but, with the fight against high inflation being the Fed’s top priority, this is also a period of rising interest rates which is normally detrimental to bonds in general. In light of these, the objective of this thesis is to assess whether the recent ascent seen in SPTL and TLT can be sustained. For this purpose, I start by detailing the two ETFs.

Detailing SPTL and TLT and Price Movements

First, both of these ETFs provide exposure to long-term treasuries as opposed to shorter-duration ones as I will touch upon later.

Now, by tracking the performance (price and yield) of the Bloomberg Long U.S. Treasury Index and charging fees of 0.06%, SPTL holds U.S. treasuries with maturities of 10 or more years as pictured below.

As for the TLT, it seeks to track the investment results of the ICE US Treasury 20+ Year Index composed of U.S. Treasury bonds with maturities greater than twenty years.

For both of these two ETFs, the average yield to maturity is nearly the same, around 3.8%.

Furthermore, compared to TLT’s weighted maturity of 25.58 years as shown below, SPTL’s government-issued bonds are of a relatively shorter duration, with an average maturity of 23.25 years.

Coming back to the recent bond price movement in the introductory chart, the returns on 10-year and above rates provide an idea of the degree of investor confidence. When investors are confident about the stock market prospects, they shy away from safe-haven assets, bringing down the price of the 10-year treasury bond, and, conversely, their yield goes up as market participants believe they can outperform long-dated bonds by investing in riskier assets such as equities. Consequently, a fall in SPTL’s or TLT’s share price, or a rise in their yields reveals a greater appetite for risk.

In contrast, when investors are scared as has been the case last week and on Monday, they mostly turn to safe havens such as treasuries and gold, in the same way as in early 2020, when the yield on US 10-year treasury bonds hit record lows as investors panicked over the Covid-induced economic crisis and flocked to US government bonds.

Viewed from this perspective, the surge in treasuries may be short-lived as the authorities have taken the relevant steps to avoid SVB-type of contagion to other banks. First, all of the bank’s deposits will be available as part of a new $25 billion guarantee facility, but, nonetheless, SVB will not be saved, which does not augur well for those holding the bag, or shareholders who did not have time to sell before it was too late. This also explains why regional banks have experienced above 40% sell-offs in their stocks.

To prevent contagion risk, there was also a joint press release on Sunday, March 12, 2023, by the chairman of the Federal Deposit Insurance Corp. (FDIC), the Federal Reserve, and the Secretary of the Treasury aimed at reassuring the customers of other banks and prevent them from going for a bank run or withdrawing their money out of panic.

However, despite the government’s backstopping and reassurance, bond prices had not retrenched back to their previous levels on Monday, and the fact that they are still up by at least 4.5% as pictured below suggests that there is another factor that determines the pricing, in addition to persisting fears of systemic risks.

Interest Rate Risks Facing SPTL and TLT and the Yield Curve

This key factor is interest rates and has adversely impacted both ETFs’ share prices as the Federal Reserve hiked interest rates in its attempt to contain high inflation, as evidenced by both SPTL and TLT’s underperformances of more than 25% in 2022 as pictured below.

For comparison purposes, I have also included the performances of the Vanguard Short-Term Treasury ETF (VGSH) and the iShares 1-3 Year Treasury Bond ETF (SHY) which have suffered from a lesser degree of volatility.

This signifies that VGSH and SHY’s short-dated bonds are less sensitive to interest rate fluctuations than longer-duration fixed-income investment vehicles like SPLT and TLT. This is because the longer a lender, in this case, the bond investor, loans his money to the U.S. government (by buying treasuries), the higher the risks he or she incurs. Now, to compensate for this higher risk, bond issuers usually get it in the form of a higher yield. This explains why the yield curve, which measures the spread between the “10-year” and “2-year” yields generally moves upwards as higher duration gets paid more for the higher risks premium.

However, this is not the case since July 2022 when the Fed was aggressively hiking rates to the tune of 75 basis points, and, as per the chart below, the 2-year in blue overshot the 10-year in orange, resulting in an inversion of the yield curve. This is something abnormal and therefore represents a relevant indicator when it comes to assessing for normality or risks in the interest rate cycle.

However, looking at the last week, there has been a drastic drop in the 2-year treasury rate, from over 5% down to 4%. If this trend continues then the yield curve will get to normal again and the 2-year rate will descend below the 10-year rate. This in turn implies that traders in the bond market may be sensing that the Fed may moderate or normalize the pace at which it tightens monetary policy. Now, since the bond market is much bigger than the equity market, this signal should be taken seriously.

Justifying a Moderation by the Fed

To further justify that there could be a moderation or even a pause in the interest rate hikes, one of the reasons for SIVB’s demise is the Federal Reserve tightening monetary policy aggressively. For this matter, just like ordinary investors like you and me holding bonds in our portfolio and getting hammered by higher rates, it was the same for SIVB except for the fact that as a large banking institution, it failed to communicate the same to regulators. Of course, there are other reasons too like the number of loans backed by startup equity.

Now, with such a stressful liquidity episode as SIVB is the most important failure since the 2008 Great Financial Crisis, the logical question which promptly comes to mind is whether the Fed will have the appetite to tighten at an aggressive pace. Thinking aloud, if anything, this failure, together with Signature Bank (SBNY) and Silvergate Capital (SI), shows that fault lines have started to appear in the liquidity front and that plugging the leaks may not be enough. This said it is more likely for the smaller regional banks to suffer compared to the big ones whose cash positions remain healthy.

Pursuing further, investors will also note that I am not alone in anticipating a moderation in the Fed’s intent as there are many others including Goldman Sachs (GS) who expect the Fed to pause. The same is the case with analysts at Barclays (BCS) who expect a pause in light of the financial distress. On the other hand, analysts at Nomura do not expect a pause as inflation “still remains above the comfort zone”.

Conclusion

In these circumstances, there are ingredients for Fed officials to moderate their rate hike trajectory at the FOMC meeting next week, at least temporarily as they assess the collateral damages caused by tighter liquidity. In this respect, with hard evidence now starting to pile up as to the degree of turmoil tighter monetary policy can trigger, there may even be a rethink of the viability of raising rates in order to tame inflation.

Therefore, there are likely to be heated debates on the subject, but for those who have witnessed how SVB’s failure highlights high-interest rate deposit account risks compared to government bonds, it is better to opt for the safety of treasuries instead of chasing high yields.

To be more specific, opt for longer-duration treasuries available through SPTL and TLT, which offer higher yields and whose prices have been performing better than shorter-duration ones during the last month as shown below.

Consequently, while the situation remains uncertain for equities when looking at the S&P 500 recent performance during the last FIVE days, a sense of normality seems to be returning in the world of treasuries, and with the Fed also having to tackle liquidity issues in addition to inflation, interest rate risks may be relegated in the background. Looking at the latest data, while CPI data remains hot, inflation has somewhat cooled off, implying that there is a higher probability of the Fed tightening by only 25 basis points next week, compared to 50. This augurs well for bond prices and assuming a 10% increase, I have targets of $33.8 (30.71 x 1.1) for SPTL and 116.4 (105.83 x 1.1) for TLT respectively.

Finally, with all the latest developments, there is a recalibration of rate bets going on as the Fed may no longer have the risk appetite to remain hawkish.

Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.