Profiting from Rising Interest Rates

In the fall of 2008, the Federal Reserve responded to the Lehman bankruptcy by igniting a rapid expansion in the US money supply. It did so because, by its lights, the immediate and obvious menace to the economy was a deflationary collapse – with one giant bankruptcy begetting another. The Fed went about the task without compromise; the monetary base more than doubled in less than a year, and the public’s M1 money supply (checkable deposits plus hand-to-hand currency) jumped by 20%.

To many investors, this policy seemed to guarantee price inflation sooner or later – which, when it arrived, would mean higher interest rates and falling prices for long-term bonds, including Treasuries. But “sooner or later” is a nearly useless observation.

In the fall of 2008, Treasury bond yields did not rise; they plummeted, as investors scurried into the safety of Teasurys. The fear brought on by the bursting of the housing bubble, tumbling stock prices, the near-death experiences of large financial institutions, and the well-publicized bailouts of public companies, trumped any concerns about inflation somewhere in the future. The compelling desire, especially among institutional investors, was to escape default risk, and that meant buying Treasuries. Inflation was a hypothetical event that could be dealt with later.

For those investors who’ve followed the inflation-vs.-deflation debate and who’ve come down on the side of inflation, shorting Treasuries looks like a sure thing. But the timing of this trade has been anything but a sure thing. Throughout the last two years, every time Treasury yields started to rise, some unexpected piece of bad news and/or exogenous event would push yields back down again: Bad news from somewhere would revive fears of everlasting recession, a new wave of defaults, or a tumble into a deflationary abyss. Housing prices would take another step down. The reported unemployment rate would stall or rise. The specter of a default in the sovereign debt of a European country would reappear. And every time, whatever the problem, it would stimulate flight-to-safety demand for US Treasury securities. So there was no sustained rise in T-bond yields. (more)