As the Federal Reserve hints at a more dovish stance and the likelihood of further rate hikes diminishes, we recognize the potential for the financial landscape to change. With inflation seemingly on a trajectory towards normalcy and stock valuations creeping back towards potentially overvalued levels, we believe an attractive risk-reward opportunity is presenting itself within the U.S. Treasury market.

The central focus of this opportunity is the U.S. 10-Year Treasury bond (Gov10). Currently priced at 95.25 with a yield-to-maturity (YTM) of 3.96%, we see potential for significant upside under the right circumstances

In assessing the potential returns of investing in Gov10, our central thesis hinges on the direction of inflation and, subsequently, its impact on the Gov10’s YTM. The Federal Reserve has reiterated its commitment to a long-term inflation target of 2%. Their unwavering stance suggests that they are likely to utilize monetary policy tools to steer inflation towards this target over the medium to long term.

Nevertheless, in our calculations, we have opted for a more conservative approach. Instead of assuming a reversion of the Gov10’s YTM towards the 2% inflation target, we assume that it falls to 2.6% in the next 24 months. This approach allows for some persistence in above-target inflation, which is plausible given recent trends.

Given this assumption, we believe there is room for the YTM of the Gov10 to decrease, which would lead to an increase in its price.

Using the formula for calculating bond prices:

Price = [C / (YTM / 2)] * [1 – (1 + YTM / 2) ^ -2n] + [F / (1 + YTM / 2) ^ 2n]

where:

  • C is the annual coupon payment ($3.38),
  • YTM is the yield to maturity (2.6%),
  • n is the number of years to maturity (10), and
  • F is the face value of the bond ($100)

we estimate that if the Gov10’s YTM declines to 2.6% over the next 24 months, the price of the bond would increase to approximately $107.29. This potential change represents a total gain of about 19.94% over the two-year period, including the bond’s coupon payments.

To calculate this total gain: Total Gain = [(New Price – Old Price) + 2Coupon] / Old Price Total Gain = [(107.29 – 95.29) + 23.38] / 95.29 ≈ 19.94%

Annualizing this total gain, we derive an Internal Rate of Return (IRR) of approximately 9.39% per annum. This annualized return is attractive, especially when juxtaposed with the current yield of the 2-year Treasury bond at 5.4%.

Moreover, should this yield contraction occur more rapidly than anticipated – say, over 18 months – the annualized return would improve further to approximately 12.64%.

Additionally, it’s crucial to consider the positioning of this trade within a broader portfolio context. The proposed strategy could act as a hedge against adverse market scenarios.

For instance, let’s consider a scenario where market conditions deteriorate and a recession emerges. Currently, the markets do not fully account for this possibility in their valuations. The materialization of a recession would likely prompt a market sell-off. However, such an environment would also likely lead to a ‘Fed Put’, a situation where the Federal Reserve steps in to support the economy by cutting rates. Consequently, the value of the Gov10 Treasury bond would likely increase, given its inverse relationship with interest rates

Finally, while historical data suggests that bonds do not necessarily provide accurate long-term inflation predictions, they do reflect the market’s inflation expectations. If these expectations normalize and align more closely with the Federal Reserve’s targets, we could expect the Gov10 YTM to decline by 100 to 150 basis points.

In conclusion, investing in the Gov10, considering the current market dynamics and potential inflation trajectory, offers an appealing risk-reward balance. Not only does it provide a meaningful return potential, but it also serves as a plausible hedge against negative market scenarios, thereby reinforcing the defensive stance of a diversified portfolio.