The Fed met this week, and there were really no surprises. They left interest rates unchanged as expected, and the statement and press conference that accompanied their decision reiterated their intention to do whatever it takes to promote growth in the U.S. economy and to try to nudge inflation upwards towards their 2% target. The stock market paid little attention, preferring instead to concentrate on the potential short-term impact of coronavirus. Bonds, on the other hand, did react, and that reaction suggests a trade in the energy sector.
After the Fed's announcement, an important part of the yield curve, the 3-Month 10-Year spread, once again inverted. Lest you have forgotten, inversion is when longer-term rates are lower than those at the short end of the curve. It is an unnatural state, as people usually demand a higher return for locking up their money for longer periods and is usually seen as a sign of trouble ahead.
There is, however, a school of thought that this time around, inversion isn't a predictor of anything, just a product of where we are now. Interest rates around the globe have been extremely low for a while and central banks have been adding liquidity for a decade. That has enabled a recovery from the recession but one thing that would normally be expected as a result, inflation, has been noticeably absent.
The yield curve inversion could be simply a reaction to that. We have had a decade of growth with low inflation; who is to say that…
The Fed met this week, and there were really no surprises. They left interest rates unchanged as expected, and the statement and press conference that accompanied their decision reiterated their intention to do whatever it takes to promote growth in the U.S. economy and to try to nudge inflation upwards towards their 2% target. The stock market paid little attention, preferring instead to concentrate on the potential short-term impact of coronavirus. Bonds, on the other hand, did react, and that reaction suggests a trade in the energy sector.
After the Fed's announcement, an important part of the yield curve, the 3-Month 10-Year spread, once again inverted. Lest you have forgotten, inversion is when longer-term rates are lower than those at the short end of the curve. It is an unnatural state, as people usually demand a higher return for locking up their money for longer periods and is usually seen as a sign of trouble ahead.
There is, however, a school of thought that this time around, inversion isn't a predictor of anything, just a product of where we are now. Interest rates around the globe have been extremely low for a while and central banks have been adding liquidity for a decade. That has enabled a recovery from the recession but one thing that would normally be expected as a result, inflation, has been noticeably absent.
The yield curve inversion could be simply a reaction to that. We have had a decade of growth with low inflation; who is to say that can't continue for another decade? The Fed could find itself cutting rates further to retain the status quo, giving low interest rates and growth concurrently.
That scenario would make one very unfashionable part of the energy sector become much more attractive.
Those with long memories may recall that in March of 2018, I wrote a piece recommending the Alerian MLP ETF, AMLP. My argument then was that the 8.3% yield of the fund was attractive in a low rate environment, especially given that oil looked set to move higher at the time. That worked out well, as AMLP gained 20% over the next five months, adding capital appreciation to that juicy dividend.
Well, we are in a similar place right now.
The yield from AMLP is actually better now than it was then.
The fund pays dividends that equate to a 9.54% return. That is remarkable when the 10-Year Treasury is yielding just over 1.5%. Obviously, the reason for the difference is the perceived relative safety of the two assets, but that perception doesn't make a lot of sense right now.
U.S. Treasuries are the "risk-free" asset off which all others are priced and for good reason. The American government has the power to tax a massive, growing economy to meet their obligations. But, given that the deficit was a record $1 Trillion last year and the national debt is well over $23 Trillion, is it really that hard to foresee a time when doubts emerge about that ability regardless?
On the other side of the equation, a glance at the chart for AMLP tells you all you need to know about the risk inherent in buying it…
As the stock market has roared over the last year, AMLP has lost around 10%. The last year or two, though, have been unusual in energy, as oil companies have reduced capex and expenditure to better position themselves for oil prices that have remained somewhat depressed and rangebound.
Investors should ask themselves whether those conditions are likely to continue for the next year or so.
The oil companies' cuts have already been made and crude is approaching a significant support level around $50. Of course, there could be more to come and WTI could break that level, but is the risk of that enough to justify the massive spread in yields?
I would say it isn't, so locking in the 9.5% in anticipation of more rate cuts looks like a reasonable, if untrendy, trade.
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