EDV: Have we seen the peak in longs? Probably not (NYSEARCA: EDV)

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hypothesis

Vanguard Extended Treasury Inc.New York: EdVIt is a fund that invests its cash in long-term Treasury STRIP notes. With a whopping 24.2 years, the fund’s performance is driven by the long end Treasury bond curve. There has been great speculation as to the eventual path of the long beavers, with unclear answers. But what has been proven in the past months is the expected trajectory of Fed funds, which have been priced to peak at 5.25% per Goldman:

Goldman

Federal Reserve Funds (Goldman)

In this article we will explore the historical relationship between 30-year interest rates and the fed funds, and attempt to draw conclusions regarding 30-year peak levels for this cycle. While history does not repeat itself like a saying, it is often harmonious, and so we feel we can use historical charts to determine the appropriate range for long peak rates.

Historic relationship between federal funds and Treasury returns for 30 years

Let’s take a look at the historical relationship between federal funds and long rates:

Fed

Fed funds vs 30y rates (Fed)

The chart above plots the federal funds rate in blue, and the 30-year fixed maturity market yield for Treasury notes. There are a number of interesting facts to note:

1) Fed funds can actually exceed 30-year Treasury yields.

  • While it may seem counterintuitive given the concept of term annuities, history has shown us that federal funds can sometimes exceed long rates.
  • Looking back nearly 20 years, we can see this disruption only occur twice, both at the end of cycles of monetary tightening.

2) Average duration of time frames with fed funds above long rates is 1 year, maximum noticeable spread is around 100 basis points

  • In looking at this historical relationship, it is important to determine the time period in which the disturbance occurred and the maximum spread observed
  • If the Fed funds outpace long-term Treasuries for just a few days, that happening won’t really matter in deducing a long-term price high for the cycle.
  • The relationship between the time frame and propagation of the two events is important in inferring similarity to the current stress cycle
Spread

Fed funds/Treasury spread 30 years (author)

  • So the two historical events are fairly well correlated, with inverse duration timeframes clocking in at about one year, with a maximum difference of 75 to 104 basis points.

3) The 2006-2007 tightening cycle also peaked with the fed funds at 5.25%

  • History often chimes, and Goldman’s peak Fed funds call in this cycle matches the highest rate seen in the 2006-2007 tightening cycle.
  • Thus, the Fed will reconsider what it did before in the not-too-distant past

If history is any guide, we should expect a similar development in this cycle. Working out the above historical schedule and Goldman’s prediction would give us a 30-year rate of 4.25% to 4.5% over this cycle. We’ve already seen buy prices touch this level before recovering:

rates

30 year prices (Investing.com)

Long rates peaked at 4.38% before retreating below 4%. As we have seen with our historical chart, the relationship does not reach its full extent until the Federal Reserve finishes raising interest rates. We expect long rates to return in the 4.25% to 4.5% ‘square’ as economic data does not come off soft and the GS path is priced in.

What does this mean for EDV?

Granted, the car only has a lifespan of 24.2 years, but the price correlation with long rates is fairly close because it spans a 20-year/30-year term structure. We saw peak bids during this cycle on October 24th, the EDV related price was around $75 per share. Would expect to revisit this but it will be a soft bottom of the box. EDV price is entirely driven by the long rates, and as we have seen from the analysis above, we expect it to peak in the 4.25% to 4.5% box.”

The fund is down 38% year-to-date due to the aggressive price hike and long duration, and is approaching the “generational buy” level. Do we think the Fed will go much higher than what the public services sector expects? number.

As interest rates on US Treasury bonds rise, so will the federal government’s borrowing costs. The United States has been able to borrow cheaply to respond to the pandemic because interest rates have been historically low. However, as the Federal Reserve increases the federal funds rate, short-term interest rates on Treasury securities will also rise — making some federal borrowing more expensive. In late May, the Congressional Budget Office projected that total annual net interest costs would be $399 billion in 2022 and nearly triple over the next decade, rising from $442 billion to $1.2 trillion:

cost

net interest cost (CBO)

A sudden rise in net interest costs is not sustainable in the long run, and rates will need to come down. This is another reason why the Fed moved so quickly – it needs to raise and then lower interest rates in the shortest timeframe to reduce both inflation and net interest costs.

conclusion

EDV is a long-term Treasury bond fund. Over the course of 24.2 years, the fund’s performance has been driven entirely by the long end of the yield curve. Despite the concept of premium, history has shown us that federal funds can be higher than long rates. In the past 20 years, we’ve had two historic instances where federal funds rates have been higher than 30-year rates, both of which occurred during previous cycles of monetary tightening. The average reversal period was one year, and the spread peaked at 100 basis points. One of these two iterations is The 2006-2007 tightening cycle when the fed funds peaked at 5.25%. With Goldman now predicting the Fed will move to a peak of 5.25% in the fed funds next year, historical correlations suggest that 30-year rates will peak at 4.25% to 4.5% “square”. This yield range indicates a “soft bottom” in EDV pricing at $75 per share.