Asset Bubbles Start Popping as Interest Rates Surge.

Asset Bubbles Start Popping as Interest Rates Surge.

It was “too good to be true” for “too long to be true”.  Nearly 38 years of falling interest rates (or RISING BOND PRICES) and a 9-year Bull Market in Equities appear to be beating a hasty retreat.  Lots of signs were there: this unprecedented period of beneficial conditions just had to end, but one could have said that 3 years or 4 years ago.

We began this summer with several pieces on the “Inflection Process” making its slow way through markets with: “Part 1:  The Long Term Equity Valuation Cycle”  (https://markonomics101.com/2018/07/12/inflection-point-part-1-the-long-term-equity-valuation-cycle/) and “Part 2 :  Financial Assets Give Way To Hard Assets” https://markonomics101.com/2018/07/15/inflection-point-part-2-financial-assets-give-way-to-hard-assets/).  Part 1 argued that a 38 year interest rate BULL MARKET had little further upside and a huge downside.  Part 2 laid the groundwork for higher interest rates and the long overdue commodity BULL MARKET.

The inevitability of change is one of the few things we can count on in the markets.  They WILL change.  We may not like how, we may not like when, and we may not like why, but being prepared for sudden change is vital.  Being prepared for “no change” is vital, too.

Higher Interest Rates Unleashed.

Not all that long ago, we were left wondering where the signs of inflations were and how interest rates could be kept SO LOW for SO LONG in: “Part 5: Interest Rates, Inflation, and Inflection” (https://markonomics101.com/2018/09/03/inflection-point-part-5-interest-rates-inflation-and-inflection/).  

The Consumer Price Index (CPI) is the official government measure of inflation.  Anecdotal evidence says, the CPI understates the rate of inflation the average consumer endures annually to keep a steady standard of living.  Yet, until recently, the 30-year Treasury Yield was BELOW the CPI and failed to either protect bond buyers against inflation OR provide a small “real return”.

In the last 10 days, the Five Year Treasury Yield (FVX), the Ten Year Treasury Yield (TNX), and the Thirty Year Treasury Yield (TYX) have taken out multi-year highs in a matter of days.  The average for Ten Year Treasury Yield, over roughly the last Half Century, is nearly 6%.  An increase in current rates of 3%, in reaching this historic 6% average, would drive all cash flow paying assets down 25% to 50%.  The Culprit?  Commodity Prices, as measured by the Goldman, Sachs, Commodity Index (GSG), has suddenly made new multi-year highs of its own.

Junk Bonds Take Nosedive on Higher Rates.

A “Junk Bond”, is merely a Corporate bond whose credit quality is not considered “investment grade” by one of the three rating agencies, Moody’s, Standard & Poor’s, or Fitch.  Investment Grade Companies are the General Electric and IBM’s with substantial revenues and cash flows which are not considered high risk to meet debt requirements.  Most corporations, not in the Fortune 500 or Standard and Poor’s 500 Index are considered “Junk”.  The terms High Yield and Junk are synonymous.  In general, “junk” is issued by smaller growth companies (New Issues) or become Junk as the fortunes of the once mighty issuer deteriorates and credit quality is downgraded.

Junk bonds trade with a “Yield Premium” to Treasury bonds which are presumed to have no credit or default risk.  Junk bonds recently have been traded at the LOWEST yield premium to Treasuries.  This means that investors were requiring a very SMALL incremental return for the inherent default risk of the bond.  Keep in mind, though, that narrow spreads may not have indicated that risk premium was insufficient, they may have indicated that the credit quality of the sector was improving.  Nevertheless, the yield premiums on Junk were approaching decade long lows and the credit risk in this sector was not adequately priced in: (https://www.zerohedge.com/news/2018-10-06/europes-junk-bond-bubble-has-finally-burst)

Junk bonds are actually a hybrid between equities and Treasuries.  Both HYG and JNK have patterns similar to the major equity indexes as, they too, are breaking down from Ascending Wedges to turn BEARISH (In Price as their yields go higher) in contrast to increasing Treasury bond prices.  The Credit Rating of any Junk Bond is of little importance in deriving value.  A few years ago, this piece called “Bond Rating Agencies Yield Junky Results” exposed the numerous conflicts of interest and the PAID FOR Credit Ratings: (https://markonomics101.com/2016/07/19/bond-rating-agencies-yield-junky-results/).  Great reading if you can stand the self-dealing and conflicts of interest that pervade Wall Street.

Precious Metals Show Early Signs of Possible Bottom.

The main driver of higher interest rates appears to be a sudden spike in commodity prices in the last month.  Led by energy prices, the Goldman Sachs Commodity Index (GSG) has made new multi-year highs.  Agricultural commodities have yet to join the party as have Precious Metals.  However, Gold (GLD) and the Junior Gold and Silver Miners (GDXJ) are finding support and are possibly tracing out short term reversal patterns.  These may be early, but bear watching.

The sudden spike in Commodities reinforces the notion that inflation has finally arrived.  As higher raw materials prices are reflected in the costs of manufacturing, the final goods produced will start costing more to reflect those costlier inputs.  Listen carefully.  That Popping Sound you here is the real thing.

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