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Watch Interest Rates – Important Story Developing

  • Written by Syndicated Publisher No Comments Comments
    May 21, 2014

    I have been a bond “bull” for a long time and reiterated that view in the middle of 2013 as interest rates spiked due to the dumping of bonds by emerging markets at that time. It was then that Bill Gross, the media and the majority of analysts said that the “bond bull market was over.”  I disagreed as I wrote:

    “For all of these reasons I am bullish on the bond market through the end of this year.   Furthermore, with market volatility rising, economic weakness creeping in and plenty of catalysts to send stocks lower – bonds will continue to hedge long only portfolios against meaningful market declines while providing an income stream.

    Will the “bond bull” market eventually come to an end?  Yes, it will, eventually.  However, the catalysts needed to create the type of economic growth required to drive interest rates substantially higher, as we saw previous to the 1980’s, are simply not available currently.  This will likely be the case for many years to come as the Fed, and the administration, come to the inevitable conclusion that we are now in a “liquidity trap” along with the bulk of developed countries.  While there is certainly not a tremendous amount of downside left for interest rates to fall in the current environment – there is also not a tremendous amount of room for them to rise until they begin to negatively impact consumption, housing and investment.  It is likely that we will remain trapped within the current trading range for quite a while longer as the economy continues to “muddle” along.”

    Today, the rate on 10-year treasury bonds broke important support and are now poised to fall further as shown in the chart below.

    Interest-Rates-vs-YieldSpread-051514

    Look at the bottom of that chart which is the spread, or difference, between the long dated 30-year treasury bond yield and the 10-year bond yield.  The last time that the difference between these two yields was this small it was concurrent with a steady decline in rates to historic lows.

      I discussed this spread recent when I wrote:

    “One of the key indicators for economic growth, or lack thereof, is the direction of interest rates. When economic activity is truly rising, the demands for credit rise also.  The chart above is the spread, or the difference, between the 30-year Treasury and the 10-year Treasury bond rates.  When this spread is rising it corresponds with stronger demand for credit and rising economic growth. When the spread falls, it is more coincident with economic weakness.”

    Interest-Rates-30-10-Spread-GDP-050714

    “The current decline in the spread suggests that “real” economic activity is likely weaker than headline data suggests. If that is indeed the case and economic activity does weaken in Q3 and Q4 of this year, then the current decline in rates is likely giving investors a clue.”

    Interest rates are likely telling us a crucial story. Outside of the always bullishly biased mainstream media and analysis, the credit markets are the lifeblood of the economy. It is also where money goes to hide when risk assets are under attack.

    In regards to the first point, there is little data currently that shows accelerating economic growth. The most recent industrial production and capacity utilization reports took sharp downturns at a time that was supposed to see a sharp post-winter surge.  Retails sales also came in extremely weak as “pent up” demand failed to emerge and is now at levels that have historically been associated with recessionary periods.

    Retail-Sales-051514

    Yesterday, I quoted Bill Dunkleberg stating the most relevant fact about what is happening in the real economy:

    “It’s tough to be excited by meager growth in an otherwise tepid economy. Washington remains in a state of policy paralysis. From the small business perspective there continues to be no progress on their top problems:  cost of health insurance, uncertainty about economic conditions, energy costs, uncertainty about government actions, unreasonable regulation and red tape, and the tax code.

    Declining interest rates are suggesting that the demand for credit is waning as real economic activity slows. This also brings into question the “capex will save the economy” meme that has risen lately.

    The second point is also salient.  When markets are under attack money rotates out of “risk” assets and into “safe” assets. I have addressed several times recently that the internals of the market were beginning to deteriorate which suggests that this particular leg of the bull market cycle may be near its conclusion.  This point was reiterated yesterday by David Tepper who manages the $20 billion distressed debt fund Appaloosa Management:

    “I am nervous. I think it’s nervous time. While the market is probably okay, it’s getting dangerous. I’m not saying go short. Just don’t go too friggin long.”

    The Central Banks are now in “Coordinated complacency…the market’s kind of dangerous in a way. I think the ECB…they better ease in June. I don’t know how far they are behind the curve…We are a fairly leveraged world…I’m not so keen about deflationary forces.  I’m more worried about deflation than inflation… First of all, I don’t know how to feel it out. I’ve never lived through it.

    If the ECB does this thing, the market’s probably OK. If they don’t do this thing, it’s not OK.

    Whether or not you like David Tepper is irrelevant. He has continually suggested being long stocks as long as the Central Banks were injecting liquidity which has been the right call.  With the Federal Reserve now extracting that support, stocks have stagnated and risks have risen.  His call of being “nervous” is the right one and interest rates are likely confirming his call.

    It has been a belief by literally 100% of economists, that when the Federal Reserve tapers its bond buying that rates will rise.  As I have shown repeatedly in the past – there is no evidence to support that case.  However, there is plenty of evidence to support that when the Fed extracts liquidity – stock prices and bond yields fall

    Interest-Rates-QE-051514

    While it is unlikely that rates will plunge immediately lower, the case for being a bit more “nervous” about the stock market is clearly being built. 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?”

    With economic data still very weak, valuations high, leverage extended and market internals weakening – the answer to that question is “a lot.”

    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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