The Interest Rate Conundrum

X-factor Report 28 June 2015

by Lance Roberts, StreetTalk Live

Over the last several weeks I have been bombarded by emails asking about the spike in interest rates. It reminds me of the old “Sanford & Son” television series where Sanford, when faced with not getting his way, grabbed his chest and tells his deceast wife that he was coming to see her.

It really should not be surprising that there is such a “fear” attached to a bump up in interest rates given the litany of commentary suggesting that the “Great Bond Bull Market” of the last 30-years is over.

If you want to the condensed version of this week’s newsletter, here it is:

“Interest rates are not going to significantly rise in the near term to any meaningful degree. In fact, it is very likely that interest rates on Government issued Treasuries will remain range bound between 1% and 4% for the next 20 years.”

Now, you can go back to what you were doing, OR you can read my reasoning as to why I believe this to be the case in the paragraphs below.

The Fundamental/Economic Case

There is a very high correlation, not surprisingly, between three economic components (inflation, economic and wage growth) 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.

Whether you agree with this premise, or not, is largely irrelevant to this discussion. The current “bullish” mantra is the “great bond bull market is dead, long live the stock market bull.” However, is that really the case?

When the bond bubble ends this means that bonds will begin to decline in price, potentially rapidly, in turn driving interest rates higher. This is the worst thing that could possible happen for stock bulls.

I say this because the stock market is ultimately a reflection of economic growth. Think for a moment about all the economic variables that are ultimately affected by changes in interest rates.

1) Since 2009, the Federal Reserve has been injecting liquidity and suppressing interest rates in order to support and foster economic growth. Therefore, if lower rates boost economic growth, what happens to economic growth when rates rise? Furthermore, if the current economic expansion is so strong, then why are Central Banks globally still intervening into the financial markets? Rising rates curtail growth as rising borrowing costs slows consumption.

2) 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.

3) Rising interest rates will immediately have a negative impact on the housing market removing that small contribution to the economy. People buy payments, not houses, and rising rates mean higher payments. (Read “Economists Stunned By Housing Fade” for more discussion)

4) An increase in interest rates means higher borrowing costs which leads to lower profit margins for corporations. This will negatively impact corporate earnings and the financial markets.

5) One of the main arguments of stock bulls over the last 5 years has been the stocks are cheap based on low interest rates. When rates rise the market becomes overvalued very quickly.

6) The massive derivatives market will be negatively impacted leading to another potential credit crisis as interest rate spread derivatives go bust.

7) 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.

8) Rising defaults on debt service will negatively impact banks which are still not adequately capitalized and still burdened by large levels of bad debts.

9) 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…badly.

10) Corporate capital expenditures are dependent on borrowing costs. Higher borrowing costs leads to lower capex.

11) Commodities, which are very sensitive to the direction and strength of the global economy, will plunge in price as recession sets in.

12) 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.

However, for those of you who still doubt that rising rates are bad for stock market returns, let me put into graphical form for you. The chart and table below show what happens to the financial markets, and the economy, when interest rates increase.

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 financial ecosystem like a virus. The rise and fall of stock prices has very little to do with the average American and their participation in the domestic 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.

However, while bond prices are near historic highs, with interest rates near lows, it would certainly seem as if bonds are in a bubble. However, if interest rates are a reflection of economic growth, inflation and wages, as the first chart above suggests, then rates are likely “fairly valued.”

The Technical Case

The economic/fundamental case is a VERY long outlook, in terms of years. However, most investors are much, much shorter-term focused.

Over the last few weeks the media has done its normal headline-grabbing spin by dragging out every bond “bear” they can find to discuss why this time, unlike like the last 30 times, is definitely the end.

Let’s put the recent “short covering squeeze” in the bond market into perspective. The chart below is a 40-year history of the 10-year Treasury interest rate. The dashed red lines denote the long-term downtrend in interest rates.

If you squint really, really hard you can almost make out the recent SURGE in interest rates. After rates dropped to their second lowest level in history of 1.68%, only exceeded by the “great debt ceiling default crisis of 2012” level of 1.46%, the recent bounce to 2.4% was expected.

As I addressed in this missive, I recommended SELLING bonds at the beginning of April stating:

“I recommended buying bonds several weeks ago when rates spiked up on rumors that the Fed might actually raise rates. (Hold on a second, I can’t see through the tears of my laughter)

Okay, I’m back. It is advisable to again take profits on a decline in rates to 1.8% or less. Bonds are going to continue to be a great trading vehicle for the next several years as the realization of a stagnationary economic environment settles in.”

The recent bounce back from that low, and consequently a very oversold level, bonds are now once again in a very attractive position to begin accumulation. As shown, rates are in the process of challenging the longer-term downtrend line at 2.6%ish and completing a 61.8% Fibbonacci retracement of the recent rate decline. With rates once again very overbought, further upside in the near term is quite limited. (I will do some additional analysis on rates in the Sector Analysis section below.)

There is an important distinction to be made here as I addressed previously in “Interest Rates, Bond Values & Your Portfolio:”

“The rise and fall of interest rates are only of concern if you own bond funds or bond related ETF’s.

Bond funds and bond related ETF’s (exchange traded funds) ARE NOT BONDS. Funds and ETF’s are a BET on the DIRECTION of interest rates just as stocks are a bet on the direction of the market. There is no return of principal function for bond funds or bond related ETF’s and, therefore, they must be managed in a portfolio just as you would manage a stock position.

However, the rise and fall of interest rates is of very little concern in a portfolio of individual bonds that are being held until maturity. The only time the level of interest rates becomes of concern is when a bond owner wishes to liquidate a bond position due to changes in the borrower’s fundamentals, credit worthiness or the bond owner needs to raise liquidity.”

Please read that missive if you DO NOT understand how bonds work. I have provided a very simplistic analysis of bonds and yield to maturity.

Just Ask Japan

Will the “Great Bond Bull” market eventually come to an end? Yes, 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 1960-70’s, are simply not available today. 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 caught within a “liquidity trap” along with the bulk of developed countries.

Furthermore, from a “buy and hold” scenario, there is not a lot of capital appreciation left with rates near historic lows. However, just because rates are low, doesn’t necessarily mean they are about to rise. Simply, take a look at Japan and you can start guessing about how long the “Great Bond Bear” will likely remain in hibernation.

Have a great week.

Disclaimer: All content in this newsletter, and on Streettalklive.com, is solely the view and opinion of Lance Roberts. Mr. Roberts is a member of STA Wealth Management; however, STA Wealth Management does not directly subscribe to, endorse or utilize the analysis provided in this newsletter or on Streettalklive.com in developing investment objectives or portfolios for its clients. Please read the full disclaimer.