Submitted by Lance Roberts of STA Wealth Management,
It was interesting over the last couple of days to watch a series of both hosts and analysts scratching their heads and fumbling for answers over the recent decline in interest rates. After all, how could this be with inflation creeping up due to much stronger economic growth? More importantly, asset prices are clearly telling investors to get out of bonds as the "great rotation" is upon us as we launch into this new secular bull market, right? IF they asked me, here would be my answers to their questions. First, a little history.
In June of last year, as interest rates were spiking, there were many calls stating that the "great bond bull market was dead." Those calls even included the great Bill Gross. The idea of the "great rotation" was born and spread through the media and the financial industry like wildfire. However, at that time I wrote an article entitled: "5 Reasons To Buy Bonds Now" stating:
"For all of these reasons I am bullish on the bond market through the end of this year.
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. 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."
Of course, since then housing has rolled over, growth of consumption has slowed, and economic growth has remained quite anemic with first quarter growth coming in at a negative 1% annualized rate.
But despite the evidence, mainstream analysis continued to err to the side of flawed analysis. I have continued to revisit this issue over the last several months reiterating my belief that interest rates remain "trapped" at lower levels due to an inability for the economy to absorb higher borrowing costs.
Reiterating Bond "Buy" – 35 Years Of History Confirms
"Bonds are currently exhibiting some of the best valuations that we have seen in the last couple of years with the technical indicators stretched to extremes. Exactly the opposite is true with the stock market with valuations (based on trailing reported earnings – the only true measure of valuations) pushing levels normally associated with bull market peaks, prices at extreme extensions and earnings peaking. This is the time when investors should be thinking about taking some profits by 'selling stocks high' and adding some relative safety by 'buying bonds low.' After all – it is what we are supposed to be doing as long term investors."
Interest Rate Predictions Meet Bob Farrell's Rule #9
"Interest rates are not just a function of the investment market, but rather the level of "demand" for capital in the economy.
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."
The recent breakdown in interest rates is simply a continuation of the thesis that I have been laying out over the course of the last year. However, let's look at a few of the most common arguments to see if they are supported by the data.
"Stronger Economic Growth Will Lead Interest Rates Higher"
That statement is only true if there is a sustainable AND INCREASING rate of economic growth over time to offset the drag caused by rising interest rates. The chart below clearly shows this to be the case.
It is important to notice that even during the rising economic growth of the 50's and 60's that increasing interest rates led to a slowdown in economic activity. This is ALWAYS the case which debunks the entire argument of most mainstream analysis that the economy can handle higher interest rates. It may appear to do so in the short term, but higher borrowing costs erode the economic underpinnings.
"Rising Inflation Will Pull Interest Rates Up"
This is another "cart before the horse issue." Inflation is a function of stronger economic growth which leads to rising wage growth which allows consumers to buy "more" stuff which leads to higher prices. Let's add to the chart above to see the relationship between all of these variables.
As you can see, wage and salary growth has the highest correlation to economic growth. With a sustainable trend in rising economic growth which leads to a corresponding trend to higher wage growth, inflation and interest rates will be remain subdued. As stated above, interest rates are a function of demand for credit. The demand for credit comes from increased levels of aggregate demand that leads to the need for higher production. Increased demand for credit by businesses increases monetary velocity through the economy which leads to rising inflation. Currently, those variables do not exist.
"The Stock Market Can Weather Higher Rates"
While asset prices can rise in the short term, particularly when fueled by massive Central Bank liquidity injections, in the longer term stock prices are a reflection of the value of the stream of future cash flows. Rising interest rates increase borrowing costs for businesses which reduces future profitability. This is why there is a very high correlation between increasing interest rates and falling asset prices as shortterm "exuberance" eventually meets "economic reality." (Read More On Chart & Table Below)
"Interest Rates Will Rise When The Fed Stops QE"
This is simply wrong. Interest rates rise when the Fed is intervening in the markets as money rotates out of "safety" and into "risk." This rotation is primarily a function of the "carry trade" as recently discussed by Jeff Saut:
"Hedge funds have been borrowing money in Japan (again) at very low Japanese interest rates, obviously denominated in yen. They then convert those yen to, say, the Brazilian real, Argentine peso, Turkish lira, etc. and buy Brazilian bonds or Turkish bonds using 10:1+ leverage. Accordingly, when such countries jacked up interest rates overnight, their bond markets collapsed. Concurrently, their currencies swooned, causing the 'hot money' investors to not only lose on their leveraged bond positions, but on the currency as well. If you are leveraged when that happens, the losses add up quickly and those positions need to be sold. So the bonds were sold, and the pesos/lira/real that were freed up from those sales had to be converted back into yen (at currency losses) to pay back the Japanese loans. And as the bonds/currencies crashed, the 'pile on' effect exaggerated the downside dive."
The chart below shows clearly that interest fall as the Fed begins extracting liquidity from the markets not vice-versa.
It is also important to notice that the deviation between stock prices and falling interest rates is soon corrected as well. While stocks have not seen a correction as of yet, the fall in interest rates suggests that the underpinnings of the financial market is weakening, and the risk of a decline has risen.
The recent decline in interest rates should really not be a surprise as there is little evidence that current rates of economic growth are set to increase markedly anytime soon. Consumers are still heavily levered, wage growth remains anemic, and business owners are still operating on an "as needed basis." This "economic reality" continues to constrain the ability of the economy to grow organically.
This is a point that seems to be lost on most economists who forget that the Federal Reserve has been pumping in trillions of dollars of liquidity into the economy to pull forward future consumption. With the Fed now extracting that support, it is very likely that economic weakness will resurface since the "engine of growth" was never repaired. 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?"
One other point to consider. As investors, we are supposed to buy when investors are fearful and sell when investors are greedy. This is advice passed on by every great investor of our time. If that is the case, then what does this really say about the quality of advice from mainstream sources that continues to espouse the chase of stocks and shunning of bonds?
via Zero Hedge http://ift.tt/1gEUYV3 Tyler Durden