How To Profit From Economists’ New Favorite Trend

How To Profit From Economists’ New Favorite Trend
Andrew Rummer

about 3 years ago3 mins

Mentioned in story

What’s going on here?

After grinding steadily lower for literally four decades, yields on US government bonds – the world’s most important market – have been breaking higher recently. To my mind, that means the time has come for you to look at the parts of the stock market that stand to benefit if this trend continues. 

What does this mean?

Investors have spent the past six months slowly moving money out of the perceived safe haven of US government debt (a.k.a. Treasuries). They’re betting that the economy will bounce back big time as coronavirus vaccination programs do their thing and governments around the globe heed new US Treasury Secretary Janet Yellen’s call to “go big” on stimulus spending. 

This collective positioning for post-pandemic economic growth and moderate inflation is being called the “reflation trade”. My inbox is stuffed with reflation-focused research reports – and web searches for the term have begun to take off.

Chart of Google searches for reflation
Google searches for “reflation” are blowing up

As the price of Treasuries has fallen, their yields have risen. The yield on the benchmark 10-year Treasury bond (effectively a contract agreeing to lend to the US government for a decade) has climbed to nearly 1.3% from an all-time low of around 0.5% in August.

Chart of yield on 10-year Treasuries

Why should I care?

Anyone invested in a classic 60/40 portfolio of stocks and bonds will have taken a small hit on the bond side recently (although gains in stocks will have made up for this). Not all industries are benefiting equally, however – and herein lies your opportunity.

While the relationship between bond yields and the overall stock market is complicated, the impact on individual sectors is much clearer cut. If you buy into the reflation thesis, then investing in US banking, energy, and chemical stocks – which have historically shown the biggest correlation with Treasury yields – is a simple way to bet on yields rising further. 

Check out how well US bank stocks (as measured by the S&P 500 Banks index) have tracked Treasury yields in the past year, for example:

chart of bank stocks versus Treasury yields

And US oil and gas stocks (as tracked by the S&P 500 Energy index) exhibit a similar pattern:

Chart of energy stocks versus treasury yields.

Conversely, the US telecom and healthcare sectors have historically been among the biggest losers in times of rising yields. 

Outperformance isn’t just sectoral, however: geography is also important. Recent analysis from Absolute Strategy Research found that stocks in France, the UK, and Spain tend to gain the most when US bond yields rise – while those in Switzerland, Sweden, China, and the US itself fare worst. 

See, for instance, how France’s benchmark CAC 40 index has tracked Treasury yields higher:

Chart of French stocks versus Treasury yields

Of course, the bond market has become notorious for repeated head fakes: suggesting Treasury yields are on the verge of turning higher, only to then reverse course and fall to fresh lows. For yields to keep climbing, we’ll need to see a true end to deflation fears. And there are plenty of commentators skeptical about that happening while unemployment remains so high and wage growth so tepid.

If you are a believer in the end of deflation, you can easily buy exchange-traded funds (ETFs) tracking all the indexes mentioned above. The SPDR S&P Bank ETF tracks US bank stocks, for example. Single-stock plays could also work – but bear the macro themes in mind before pulling the trigger.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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