Watch Yields: Essential Insights & Strategies for Maximizing Returns 📈

GM. This is Milk Road, your go-to newsletter helping you navigate the complexities of the bond market and its impact on your investment portfolio. Here’s what we have in store for you today:

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Last Wednesday, we found ourselves at another pivotal moment. The future trajectory of Bitcoin was contingent on oil prices: if they remained below approximately $95, a rally seemed likely; conversely, if they surged past $100, Bitcoin could face challenges. Since that time, Brent crude oil has closed at $103.08, rising by about 4%, leading to a 2.1% drop in Bitcoin prices, while the 10-year Treasury yield jumped by 15 basis points in just one day.

Currently, WTI is trading around $92.84, staying below the $95 threshold, whereas Brent is at approximately $105.81, exceeding the $100 mark. This situation presents a dual narrative—Bitcoin is currently valued at around $83.9K, remaining above the May high of roughly $82.8K throughout this volatile period. The dynamic would be simpler if the 10-year yield mirrored the fluctuations in oil prices. Oil has experienced significant volatility this month, swinging from $108.75 on September 15 to $99.25 by last Tuesday before rebounding back to around $105.81. In contrast, the 10-year yield has taken a steady ascent from 5.00% to 5.24%, increasing by 24 basis points since the Fed’s last interest rate hike. Additionally, John’s Macro Index has dropped to -0.87 as of Monday, reflecting ongoing trends in the bond market.

Breakeven inflation may seem like a term to gloss over, but it’s essential to track closely at this time. The 10-year yield represents a combination of market inflation expectations and the additional compensation investors demand for lending money. The yield on September 15, right before the Fed’s rate hike, was 5.00%, with expected inflation at 2.38%, resulting in a real yield of approximately 2.62%. As of Monday, the yield climbed to 5.24% against an expected inflation of 2.34%, yielding a real return of around 2.90%. This shift signifies that bond investors are seeking higher compensation for lending to the U.S. government, despite a slight dip in inflation expectations.

To put it simply, anticipated inflation can be viewed as market predictions of future grocery prices, while the real yield signifies the added return you expect for lending your funds in the interim. The forecast for inflation has decreased from 2.38% to 2.34%, while the yield has increased by approximately 28 basis points. This leads to a crucial inquiry: If bond investors are not overly concerned about inflation driven by oil prices, what are their actual concerns?

While many would point to oil as the primary concern—given its prominence in recent discussions—there are also factors hidden within a less active segment of the bond market that warrant attention.

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In our previous commentary last Wednesday, we noted the divergence between the 2-year yield and the 30-year yield, highlighting the inconsistency in their movements. Since September 15, the day preceding the Fed’s rate hike, the 2-year yield has risen by 25 basis points to 4.92%, while the 10-year yield increased by 24 basis points, and the 30-year yield rose by 20 basis points to 5.56%. The entire curve has shifted in response.

The 2-year yield reflects market expectations regarding the Fed’s actions in the near term, while the 30-year yield relates to long-term economic outlooks. This simultaneous movement suggests that lenders harbor concerns about different aspects of economic conditions. In the short term, worries include a Fed that continues to raise rates amid a robust economy, with oil serving as a significant factor in this equation. Looking further out, the focus shifts to the term premium.

Bond investors are pricing in a scenario where the Fed persists in hiking rates while the economy remains strong, with oil prices contributing to this uncertainty. It’s worth noting that the Fed acted first, implementing a rate hike on September 16—its first increase since 2023—while traders currently estimate a greater than 70% probability of another hike at the upcoming October 27-28 meeting. As John pointed out on Monday, economic indicators do not suggest a reason for the Fed to halt its tightening measures. The Atlanta Fed’s GDP tracker indicates a growth rate of approximately 5.0% for this quarter, accompanied by a decrease in jobless claims to around 197,000.

So, does oil still hold significance? Yes, particularly in relation to the Fed’s decisions. August’s headline inflation rate stood at 3.4%, while core inflation was at 2.4%, with the variance primarily attributed to rising gasoline prices. The oil market itself is tighter than WTI prices might suggest; the November Brent contract is currently priced about $7.72 higher than December contracts, up from $5.44 on September 15 and $3.84 last Tuesday—indicating that buyers are willing to pay a premium for immediate delivery. With the November contract expiring tomorrow, part of this premium can be attributed to the typical price adjustments associated with expiration.

However, two weeks’ worth of data is insufficient to definitively attribute the recent movements to oil fluctuations or the Fed’s ongoing momentum. What might bring real yields back down? Two possibilities arise: a decrease in oil prices could convince traders to reassess the likelihood of further rate hikes, or economic growth might slow enough to alleviate the Fed’s need to continue tightening. The latter scenario seems distant, with GDP tracking at around 5.0% and jobless claims near their lowest levels, shifting the burden primarily onto oil prices and forthcoming statements from the Fed, particularly with PCE data due Wednesday and CPI scheduled for October 14.

This brings us to gold… Traditionally viewed as a safe-haven asset, gold prices have fallen from approximately $4.32K to $4.17K since Friday’s newsletter—a 3.4% decline that surpasses the losses experienced by the Nasdaq and S&P 500. Gold does not yield interest, and the increase in the 10-year Treasury yield explains this dip. In contrast, Bitcoin remains relatively stable, hovering around $83.9K after closing at roughly $84.5K last week. Like gold, Bitcoin does not pay interest, and the current 5.2% Treasury yield poses significant competition it hasn’t faced since 2007. Should oil prices decrease and expectations for rate hikes diminish, the pressure on both assets may ease. Conversely, if the Fed continues its tightening strategy, gold’s recent decline could foreshadow potential challenges for other yieldless assets, including Bitcoin.

In summary, the relationship between gold and rising yields could serve as a precursor for Bitcoin’s future movements. The critical support level for Bitcoin remains the May high of about $82.8K, and it continues to remain above that threshold. While oil plays a role in this narrative, since the Fed’s rate hike, the 10-year yield has risen due to real yields, despite a slight decline in inflation expectations. This indicates that a resolution leading to lower oil prices could be beneficial, but may not solely suffice to lower yields. Both gold and Bitcoin have been subjected to the same yield pressures throughout the week, with gold experiencing a notable pullback of around 3.4%, while Bitcoin has shown resilience. The key factor to monitor moving forward will be real yields, as the interplay between rising oil prices and upcoming actions from the Treasury and the Fed will dictate the next moves across various asset classes.

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