The Interest Rate Bomb: Is The Fuse Now Lit?
Recently, we noted the critical role that higher inflation and interest rates would play in The Inflection Process. Furthermore, the levels of interest rates seemed so low as to make very little logical sense (https://markonomics101.com/2018/09/03/inflection-point-part-5-interest-rates-inflation-and-inflection/.) Not only does “reported” inflation (currently 2.9% annually) seem to vastly understate what most of us experience in real life, but the level of interest rates is so low as to provide bondholders with a negative “real return”. (“Real” meaning after inflation).
At that time, about 10 days ago, there was virtually NO existing market-based sign which would validate rates would head higher anytime soon. One could only say that rates were absurdly low, but there is an historic tendency of markets to remain over or under valued for extended stretches of time. That’s Mr. Market’s way of lulling all his pigeons into complacency, so he can pluck all their feathers at a future time when they aren’t looking.
Markonomics101, with no agenda but truth and accuracy, is always looking (https://markonomics101.com). In the last 10 days or so, the picture previously outlined has shifted remarkably. And, in the direction that was anticipated. (It doesn’t always. Mr. Market thrives on doing exactly the opposite).
The entire complex of Treasury yields, including 5, 10, and 30 Year Maturities, appears to be establishing a new and confirmed Uptrend in Rates. Keep in mind, that interest rates and Bond Prices are inversely related. Higher rates mean lower Bond Prices and are therefore considered BEARISH. Higher rates, all things being equal, mean lower equity prices and tend to depress the value of any form of Wealth which is derived from a cash flow stream.
(* The Ten Year Treasuries chart information should read: “Ten Year Treasuries have decisively broken out of a Triangle at the 3% barrier, now establishing interest rates as heading HIGHER“.)
Note that the Five Year, 10 Year, and 30 Year Treasury Yields have either exceeded, or appear set to exceed, the 3% barrier which has held them artificially low for years. The charts of these rates over the last 20 years can be found in our piece called “Interest Rates Continue To Edge Higher” (https://markonomics101.com/2018/09/15/interest-rates-continue-to-edge-higher/). Markets are difficult to manipulate for very long. At some point, holding rates artificially low is like trying to hold a beach ball under water. Lenders just will not accept such inadequate returns if other asset classes provide better ones. Borrowers, like our friends in the Federal Government, are only too happy to underpay. (Sounds illegal doesn’t it?)
Some potentially additional confirmation has shown up in the changing rate picture from two other sources: Utility stocks and the Dollar. The US Dollar Index would typically reflect inflation, or substandard interest rates, by falling from a reduction in demand. Inflation is the excess creation of Dollars versus Goods and Services. If too many Dollars are created relative to Goods, then the price of those Goods will increase. The Hyperinflation currently threatening Argentina and ravaging Venezuela are two current examples of too many “Bolivars” or “Pesos” chasing too few goods.
Utility prices are directly impacted by interest rates because they typically distribute the bulk of their profits to shareholders as dividends. They generally increase dividends slowly over time, but they are valued as the present value of their future cash stream. A perfect analogy would be an apartment building which produces rents for the owners and those rents slowly increase over time. In contrast, bonds pay the same interest rates for their entire maturity period so must yield a cash stream over the whole time period which guards against inflation to keep the bond owner whole.
Just yesterday, the Dow Jones Utility Average broke down sharply from an Ascending Wedge. Since Utility earnings are fairly steady, the main reason is probably a reaction to the expectation or realization of HIGHER INTEREST RATES. The US Dollar Index has also broken down from a Triangle and is now BEARISH. A lower Dollar reflects devaluation against other currencies and the anticipation of inflation.
A key driver of inflation expectations is Commodity Prices. There too, we have the first signs of potential confirmation of inflation. The Goldman Sachs Commodity Index (GSG), pictured below, shows the possible beginning of a surge higher with an Upside breakout. Finally, we have GOLD. Stodgy old GOLD. Clearly still in a BEARISH Pattern, but it too is unlikely to ignore higher signs of inflation as they become more visible. While it’s still too early to look at Gold as signaling anything, investor demand will certainly push it higher if the inflation genie is let out of the bottle.
The last Tipping Point is looking more and more likely to be on our doorstep. The next challenge for investors will be to adapt to the new reality as it unfolds. We will be describing different ways of protecting wealth in the new environment. Don’t miss a single issue. Please join our growing subscriber list! Our price won’t go up. Our value, however, will!