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Interest Rate Predictions Meet Bob Farrell Rule No.9

  • Written by Syndicated Publisher No Comments Comments
    April 30, 2014

    An interesting article hit my inbox this morning from WSJ MarketWatch which was titled“100% Of Economists Think Yields Will Rise Within 6 Months.” From the article:

    “Economists are unwavering in their assessment of where yields are headed in the next half year.

    Jim Bianco, of Bianco Research, points out in a market comment Tuesday that a survey of 67 economists this month shows every single one of them expects the 10-year Treasury yield to rise in the next six-months.”

    This is very striking from the standpoint that a separate poll of economists showed that there were none, zero, nada expecting an economic contraction either.

    With literally 100% of all surveyed economists bullish on the economy it suggests that there is nothing but clear sailing ahead for investors. Of course, it is also important to remember that it was this same group of “economists” that have been predicting the return of economic growth and higher interest rates for the last three years, as well. As we enter into the sixth year of the current economic expansion the unanimous “bullish bias” is indeed fascinating.

    As I read the article, I was nearly deafened by the voice in my head screaming Bob Farrell’s Rule #9 which simply states:

    “When all the experts and forecasts agree – something else is going to happen.”

    Almost one year ago, after interest rates initially spiked from historic lows, I begin writing then that the bond “bull” market was not yet over despite the litany of articles and punditry claiming otherwise. Furthermore, I stated that interest rates would be lower in the future than they were at that time because the three primary ingredients needed for higher rates which were not present: rising inflation, increased wage growth and economic acceleration.

    As I stated then in “Reiterating Bond Buy:”

    However, there are three reasons to add bonds to portfolios currently:

    1) As discussed recently investors tend to do the opposite of what they should investment wise by panic selling market bottoms and buying market tops. Currently, unlike the stock market which remains extremely overbought on an intermediate term basis, bonds have had a substantial correction in price which now makes them technically very attractive in the short term for a trading opportunity.

    2) The “quest for yield” isn’t over as long as the Federal Reserve continues to keep “accommodative rate policies” in place that keep money market rates near zero. With “baby boomers” rapidly heading into retirement, following two nasty bear markets that took away 50% of wealth, the allure of “safety” and “income” are the keys to their current psyche.

    3) Money flows into U.S. Treasuries will likely increase as the slowdown in European, and Asian, economies seek safety and stability of the U.S. As pointed out by Jeff Gundlach, manager of Doubleline Total Return Bond Fund, recently reiterated the same call stating:

    “The liquidation cycle appears to have run its course with emerging market bonds, U.S. junk bonds, muni’s and MBS—all of which substantially underperformed Treasuries during the rate rise—now recovering sharply,”

    With the reality that the economy has likely peaked for this current economic cycle, deflationary pressures rising and the potential for less monetary interventions in the quarters ahead, the catalysts for higher bond prices are tilted in investor’s favor currently.”

    However, even if you don’t buy those arguments it is hard to disagree with the fundamental drivers of interest rate growth as stated above. The chart below shows the long term analysis of the 10-year treasury rate as compared to the Consumer Price Index (as a measure of inflation), economic and wage.

    Interest-Rates-Wages-GDP-CPI-042314

    As you can see there is a very high correlation, not surprisingly, between these three components and the level of interest rates. Interest rates are not just a function of the investment market, but rather the level of “demand” for capital in the economy. When the economy is expanding organically the demand for capital rises as businesses expand production to meet rising demand. Increased production leads to higher wages which in turn fosters more aggregate demand. As consumption increases, so does the ability for producers to charge higher prices (inflation) and for lenders to increase borrowing costs.

    However, in the current economic environment this is not the case. The need for capital remains low, outside of what is needed to absorb incremental demand increases caused by population growth, as demand remains weak. While employment has increased since the recessionary lows much of that increase has been the absorption of increased population levels. Many of those jobs remain centered in lower wage paying and temporary jobs which does not foster higher levels of consumption.

    Businesses, as discussed earlier this week in “House Of Cards,” are focused an managing corporate profitability in the face of extremely low revenue growth over the last five years. In turn, the focus for those companies has remained increasing productivity while suppressing employment levels and wage growth.

    There is little evidence currently that the current rates of economic growth are set to increase markedly anytime soon. Consumers are still heavily levered, wage growth remains anemic and business owners are still operating on an “as needed basis.” This“economic reality” continues to constrain the ability of the economy to grow organically. This is a point that seems to be lost on most economists who forget that the Federal Reserve has been pumping in trillions of dollars of liquidity into the economy to pull forward future consumption. With the Fed now extracting that support, it is very likely that economic weakness will resurface once again since the “engine of growth” was never repaired.

    The point here is that as a contrarian investor, when literally “everyone” is piling on the same side on any trade it is time to step back and start asking the question of “what could go wrong?” Despite the fact that interest rates have already fallen from their peak, and as I addressed in my recent newsletter is creating a “buy” for bond investors, bond bearishness is still at historic extremes.

    It is at times like these that I fall back onto Howard Marks’ sage advice:

    “Resisting – and thereby achieving success as a contrarian – isn’t easy. Things combine to make it difficult; including natural herd tendencies and the pain imposed by being out of step, since momentum invariably makes pro-cyclical actions look correct for a while. (That’s why it’s essential to remember that “being too far ahead of your time is indistinguishable from being wrong.”)

    Given the uncertain nature of the future, and thus the difficulty of being confident your position is the right one – especially as price moves against you – it’s challenging to be a lonely contrarian.”

    One other point to consider. As investors, we are supposed to buy when investors are fearful and sell when investors are greedy. This is advice passed on by every great investor of our time. If that is the case, then what does this really say about those chasing stocks and shunning bonds currently? Then again, as it is always hoped, this time could be different.

    Images: Flickr (licence attribution)

    About The Author

    Lance Roberts – Host of StreetTalk Live

    After having been in the investing world for more than 25 years from private banking and investment management to private and venture capital; Lance has pretty much “been there and done that” at one point or another. His common sense approach has appealed to audiences for over a decade and continues to grow each and every week.

    Lance is also the Chief Editor of the X-Report, a weekly subscriber based-newsletter that is distributed nationwide. The newsletter covers economic, political and market topics as they relate to the management portfolios. A daily financial blog, audio and video’s also keep members informed of the day’s events and how it impacts your money.

    Lance’s investment strategies and knowledge have been featured on Fox 26, CNBC, Fox Business News and Fox News. He has been quoted by a litany of publications from the Wall Street Journal, Reuters, The Washington Post all the way to TheStreet.com as well as on several of the nation’s biggest financial blogs such as the Pragmatic Capitalist, Zero Hedge and Seeking Alpha.
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