May 6th, 2014
by Lance Roberts, Streetalk Live
Before I get into our discussion on interest rates today, it is very interesting that despite better than expected earnings, encouraging comments by the Federal Reserve and a stronger than expected employment report - stocks were unable to decisively break out of the trading range that has existed since the beginning of March.
Importantly, despite the turmoil of the markets over the last couple of months, complacency has risen sharply in the last few weeks. This is shown by the decline of the volatility index (bottom part of the chart above) back to extremely low levels. For investors the concern is that, as discussed in Friday's missive, May tends to be one of the weakest months of the year for stocks to wit:
"Historically, May is the 3rd worst performing month for stocks on yielding an average return of 0.27% and a median return of 0.49%. The chart below graphically depicts the disparity of monthly average and median returns."
"May, as shown in the chart above, also represents the start of the "seasonally weak" time for stocks. As the markets roll into the early summer months, May and June tend to be some of weakest months of the year along with September. This is where the old adage of "Sell In May" is derived from. Of course, while not every summer period has been a dud, history does show that being invested during summer months is a "hit or miss" bet at best as shown in the next chart of historical returns for May back to 1900. While May's monthly average is skewed by sharp deviations in returns during the "Great Depression," more recent years have been primarily contained, with only a couple of exceptions, within a +/- 5% return band as shown below."
One last point, as I discussed in "Sell In May Particularly During Mid-Term Election Years:"
"While there are some years that have posted sizable gains during the summer months, such years do not invalidate the long term statistical probabilities. As the table shows above, the average annual return from the summer months is significantly poorer than the fall and winter. To show the impact of that performance differential, I constructed the following chart which shows the growth of $10,000 invested in each of the seasonal periods."
Now, with that background in place let's discuss interest rates and what they are potentially telling us about the broader financial landscape.
It's Either This Or That
I wrote recently about a survey that showed 100% of economists surveyed expect interest rates to rise in the next six months. To wit:
"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 increase in the next six-months."
Furthermore, there was a separate poll taken that showed 100% of economists do NOT expect an economic contraction either.
The problem is that it cannot be both. It is either this or that.
First of all, when there is a COMPLETE consensus on anything, it is very likely that something else will happen. It is one of the primary rules of market dynamics.
Secondly, interest rates are nothing other than the reflection of the supply/demand for credit. In this regard there are THREE primary drivers to move interest rates: economic growth, wage growth and inflation. This is clearly shown in the chart below.
The employment report on Friday that showed a whopping 288,000 jobs created at the headline, due to seasonal adjustments, obfuscated the fact that 75,000 were LOST at the household level. Furthermore, since the majority of the jobs created were in the lowest wage paying areas of the economy - wages remained stagnant for the month. Without wage growth, there cannot be an increased demand for credit in an already overleveraged economy. This will also mean that inflation remains suppressed along with economy growth.
Lastly, rising interest rates have a variety of negative impacts on the financial markets and economy.
- The Federal Reserve has been buying bonds for the last 4 years in an attempt to push interest lowers to support the economy. The recovery in economic growth is still dependent on massive levels of domestic and global interventions. Sharply rising rates will immediately curtail that growth as rising borrowing costs slows consumption.
- The Federal Reserve currently runs the world's largest hedge fund with over $4 Trillion in assets. Long Term Capital Mgmt. which managed only $100 billion at the time, nearly brought the economy to its knees when rising interest rates caused it to collapse. The Fed is 40x the size and growing.
- Rising interest rates will quickly kill the housing market taking that small contribution to the economy away. People buy payments, not houses, and rising rates mean higher payments. (Read "Economists Stunned By Housing Fade" for more discussion)
- An increase in interest rates means higher borrowing costs which lead to lower profit margins for corporations. This will negatively affect corporate earnings and the financial markets.
- One of the main arguments of stock bulls over the last 5 years has been that stocks are cheap based on low interest rates. When rates increase, the market becomes overvalued very quickly.
- The massive derivatives market will be negatively impacted leading to another potential credit crisis as interest rate spread derivatives go bust.
- As rates increase so does the variable rate interest payments on credit cards. With the consumer being impacted by stagnant wages and increased taxes, higher credit payments will lead to a rapid contraction in income and rising defaults.
- Rising defaults on debt service will negatively impact banks which are still not adequately capitalized and still burdened by large levels of bad debts.
- Many corporate share buyback plans and dividend issuances have been done through the use of cheap debt, which has led to increases corporate balance sheet leverage. This will end.
- Corporate capital expenditures are dependent on borrowing costs. Higher borrowing costs leads to lower capex.
- Commodities, which are very sensitive to the direction and strength of the global economy, will plunge in price as recession sets in.
- The deficit/GDP ratio will begin to soar as borrowing costs rise sharply. The many forecasts for lower future deficits will crumble as new forecasts begin to propel higher.
I could go on, but you get the idea. Rising interest rates are a drag on economic growth because of the increased cost of capital. As the cost of capital increases, the rate of return on invested capital also rises to justify borrowing costs. In a weak economic environment, there is only the most narrow of margins between profitability and loss.
The bottom line is that interest rates ARE NOT likely to rise materially in the next six months, or in the next six years. For a clear look at what happens when an economy hits the debt/leverage "wall," combined with an aging population and low interest rates - take a look at the chart below.
Nobody ever thought that Japan would still be wrestling with low interest rates 16 years later.
As I wrote previously on this issue:
"While Japan has entered into an unprecedented stimulus program (on a relative basis twice as large as the U.S. on an economy 1/3 the size) there is no guarantee that such a program will result in the desired effect of pulling the Japanese economy out of its 30-year deflationary cycle. The problems that face Japan are similar to what we are currently witnessing in the U.S."
- A decline in savings rates to extremely low levels which depletes productive investments
- An aging demographic that is top heavy and drawing on social benefit schemes at an advancing rate.
- A heavily indebted economy with debt/GDP ratios above 100%.
- A decline in exports due to a weak global economic conditions.
- Slowing domestic economic growth rates.
- An underemployed younger demographic.
- An inelastic supply-demand curve
- Weak industrial production
- Dependence on productivity increases to offset reduced employment
The unanswered question remains as to whether, or not, monetary policy can generate economic recovery. The world's central banks have "bet it all" that it will indeed work. The problem, as is always the case is such financial experiments, remains the unintended consequences.
The lynch pin to both Japan and the U.S. remains interest rates. If interest rates rise sharply it is effectively "game over" as borrowing costs surge, deficit's balloon, housing falls, revenues weaken and consumer demand wanes. It is the worst thing that can happen to an economy that is currently remaining on life support.
Japan, like the U.S., is caught in an on-going "liquidity trap" where maintaining ultra-low interest rates is the key to sustaining an economic pulse. The unintended consequence of such actions, as we are witnessing in the U.S. currently, is an ongoing battle with deflationary pressures. The lower interest rates go - the less economic return that can be generated. An ultra-low interest rate environment, contrary to mainstream thought, has a negative impact on making productive investments and risk begins to outweigh the potential return.
The mistake that Japan is likely going to make is in believing that if they can create some inflation for the economy, that they will have the ability to cap it at 2%. This is beyond naive and is likely to end very badly."
Just the small increase in U.S. interest rates since last year has already seen a rather large revulsion in the housing market and a contraction in consumer spending and revenue growth. If that happened with only a 1% increase in interest rates can you imagine what will happen with a "substantial increase" from current levels?
The Thin Line Between Love And Hate
When it comes to the stock market, it is believed that rising interest rates will not affect the current cyclical bull market. This is also awful analysis. Given the fact that the majority of "bullish" outlooks are based on the argument that "low interest rates justify higher valuations," such an argument vaporizes when rates rise. However, for those of you who still need convincing, look at the chart and table below.
The problem with most of the forecasts for the end of the bond bubble is the assumption that we are only talking about the isolated case of a shifting of asset classes between stocks and bonds. However, the issue of rising borrowing costs spreads through the entire business ecosystem like a virus. The rise and fall of stock prices have very little to do with the average American and their participation in the national economy. Interest rates, however, are an entirely different matter.
What would be required to diminish the impact of bursting bond market bubble is a slow, and controlled, unwinding of the bond market over an extremely long period of time. The Fed would have to step up interventions on a massive scale to offset the selling of the bond market to curtail the rise in rates. Even with that, I would expect a rather sharp economic deceleration as the housing market grinds to halt and overall consumption declines. The actual achievement of such a counter balance to a market as large as the bond market is difficult to fathom.
Interest Rates Set To Decline
However, with the Fed now extracting their support, economic strength waning and deflationary pressures still prevalent - it is unlikely that rates will rise anytime soon. The recent decline in interest rates, as we have been predicting would occur since last May when I first suggested a "bond buying" opportunity, has now gotten back to the bottom of its current trading range.
Without real signs of a strengthening economy, as shown by very weak factory orders last week, it is possible that with the Fed extracting support from the markets rates will decline further.
"But Lance, everyone on the media says that when the Fed pulls their support, rates will rise."
Um...yes...that is just wrong. See the next chart.
The result of QE programs actually caused interest rates to rise, despite the mainstream media's inability to look at a chart. This is because the stimulus caused money to leave "safety" and move into "risk." However, as we have seen since the beginning of the year as the Fed now extracts their support for the financial markets - money has been rotating out of risk (biotech's and technology) and back into dividend yielding stocks and bonds.
As I discussed recently, there is an ongoing belief that current financial market trends will continue to head only higher. This is a dangerous concept that is only seen near the peak of cyclical bull market cycles.
"We saw much of the same analysis as Brad's at the peak of the markets in 1999 and 2007. New valuation metrics, IPO's of negligible companies, valuation dismissals as 'this time was different,' and a building exuberance were all common themes. Unfortunately, the outcomes were always the same. It is likely that this time is 'not different' and while it may seem for a while that Brad analysis is correct, it is 'only like this, until it is like that.'"
The point here is that while the current trends can last longer than reasonably believed, which is why we currently remain invested in the markets; it is inevitable that things will change. The problem for most is that by the time they recognize that the underlying dynamics have changed it will be too late to be proactive, only reactive. This is where the real damage occurs as emotional behaviors dominate logical processes.
Have a great week.