November 6, 2024 | Issue 86

Should You Buy US 10Y Treasury Bonds? A Second-Level Thinking Approach

Nikolay Stoykov
Managing Partner at Alaric Securities

These days, making it in the markets takes more than just following the crowd. When it comes to investments like US 10Y Treasury Bonds, relying on what’s in plain sight isn’t enough—you need what’s called “second-level thinking.” This article explores how this deeper approach can make a difference—and maybe even save you from falling into some classic market traps.

First-Level vs. Second-Level Thinking

It is widely accepted nowadays that to succeed in trading, one needs to develop the ability to think at a “second level.” We often get asked for an example of such thinking, and I will give you my favorite example.

First-level thinking: If it looks like a duck and quacks like a duck, it must be a duck.

Second-level thinking: If it looks like a duck and quacks like a duck, it might be a duck. However, it also can be a duck dummy with a hunter hidden in the bushes, holding a loaded shotgun and blowing a whistle that sounds like a duck. A further investigation is required.

The difference should be evident to you—first-level thinking is simple and easy. It leaves us with no doubt about what we are observing. That is the level of thinking that we are born with. Before age 10, it might be impossible or at least challenging for children to believe at a second level.

Why Most People Avoid Second-Level Thinking

Second-level thinking is slow and energetically demanding, and very often, even if a conclusion can be reached, that conclusion is always in doubt. It could be beyond reasonable doubt, but not beyond absolute doubt. I guess our readers can understand why most people prefer first-level thinking – if you choose to think at a second level, that would not only be a very taxing way of thinking, but also doubt about what you observe will always be there. And people desperately want to be correct.

If it looks like a duck and quacks like a duck, it is most likely a duck. However, if it turns out to be a hunter with a loaded shotgun, you might not be able to walk away from this mistake. Invariably, first-level thinkers will walk into that trap. Second-level thinkers are not immune from making that mistake either, but at the very least, they have a chance.

The Effort and Uncertainty of Thinking Deeper

Fortunately, if you want to be a second-level thinking actor without doing excessive investigations, you can trust practices that have survived the test of time. One such practice is that when buying a home, the homebuyer should put a 40% down payment and have at least 3 months of mortgage payment worth of savings. Of course, it is possible to buy a house with 0% down and live paycheck to paycheck, but that practice has not survived the test of time – it works sometimes, but most of those risky buyers probably lost their house to foreclosure.

You need to invest much time investigating anything deeply with second-level thinking. Sometimes, it takes 10 years of careful study to truly understand a subject well. But that’s impractical, right? That’s why we rely on experts: you go to a dentist, not DIY dental work; you see a mechanic, not fix your car. Very often, you don’t know those experts personally, but they come with credentials, and you trust them with your health or safety.

Applying Second-Level Thinking to Financial Markets

It is always amazing to me how, when it comes to the financial markets, people are utterly unwilling to think at a second level or genuinely seek guidance. Even when they do seek guidance, the search is quite a first-level thinking effort!

Guidance on the markets comes from what I call “betting lines.” Similar to sports lines, one can observe betting lines in the markets. We will refer to those lines as the “wisdom of the crowd.

Let’s get to the topic we wanted to discuss – 10-year interest rates:

hart showing the relationship between 10Y US Treasury Bonds yields and the Federal Funds rate over time, illustrating recent trends where Fed rate cuts coincide with rising 10Y Treasury Bond yields.

Courtesy of tradingeconomics.com, pictured in blue – US 10-year rates, pictured in green – Fed Funds

As you can see, when the Fed starts lowering rates, 10-year rates go down. However, even though the Fed started lowering rates, 10-year rates are going up. Could this be a duck dummy with a hunter waiting, or is this a duck? Is this an opportunity to buy bonds on the cheap or potentially the last trade of your trading career?

Is Now the Time to Buy US 10Y Treasury Bonds?

Let’s examine the market lines. We’ll examine the Treasury Inflation-Protected Securities (TIP) maturing in April 2025 and the 6-month US interest rate.

Consider two dates: the beginning of October 2024 and the end of October 2024.

On 1/10/2024, the 10-year US rate was at 3.73%, the 6-month rate was 4.36%, and TIP maturing 4/2025 yielded 3.47%. This implies that on that date implied annualized inflation until 4/2025 would be = ( 1+ 6M Rates)/(1+TIP Rate)- 1 = (1+4.36%)/(1+3.47%)-1 = 0.86% annual inflation rate.

On 31/10/2024, 10-year US rates were 4.28%, 6-month US rates were 4.48%, and TIP maturing 4/2025 yielded 3.18%. Therefore, implied inflation until that date on an annualized basis would be = (1+4.48%)/(1+3.18%)-1 = 1.26% annual inflation rate. This suggests that inflation expectations for the next 6 months have increased, which could have implications for your investment strategy.

So, 10-year rates increased by 0.60% while inflation expectations for the next 6 months increased by 0.40% annually. That is not necessarily an overreaction. What is an overreaction is that even the new “elevated” levels of expected inflation for the next 6 months are pretty low!

Yes, the wisdom of the crowd suggests that inflation will stay low in the next six months—below the Fed’s 2% target. And with 10-year rates at elevated levels, it’s unrealistic to think they’ll stay high for long. So, maybe this is indeed a duck, not a trap.

In short, we’re not afraid to buy bonds here.

Disclaimer

The articles, podcasts, and newsletters from Alaric Securities OOD solely represent the authors’ views affiliated with the company. They do not mean the perspectives of Alaric Securities OOD or any of its subsidiaries or affiliates. They are provided for informative purposes and do not constitute recommendations for or against purchasing or selling security. Digital assets (such as cryptocurrency) or other assets in any account. They are neither research reports nor meant to be the foundation for any investing decisions. Any third-party information given does not represent the views of Alaric Securities OOD or any of its subsidiaries or affiliates. All investments carry risk, including the potential loss of principal, and past success does not assure future success.