We’ve discussed various times how interest rates are set to rise, possibly faster than fed funds futures are currently pricing, and how higher rates could be the undoing of the bull market. Today’s investing advice explores the possibility more deeply.
Our concerns are currently being borne out, as yesterday Jerome Powell, the new head of the Federal Reserve, held his first press conference following the expected 25 basis rise in Fed fund rate.
Powell struck a no-nonsense tone, displaying his determination to continue on a path of normalization. In other words, a higher interest rate environment. Stocks initially rose, but as the implications sunk into investors’ brains, shares began to suffer.
Michael Lebowitz of 720 Global provided a post-FOMC report in which he tells investors to Buckle Up for Turbulence Ahead.
U.S. Treasury securities across the maturity spectrum are reaching yield resistance levels that have proven for decades to be extremely valuable to investors engaged in technical analysis.
I believe it is possible that the reaction of interest rates to these resistance levels will hold important clues about future economic activity and the direction of the stock market.
While it is certainly possible that Treasury yields meander and prove these decade-old technical levels meaningless, strategic planning for what is certainly a heightened possibility of large asset moves is always wise.
Many investment pundits are scoffing at the recent increase in Treasury yields. Since record low yields were set in mid-2016, the ten-year U.S. Treasury note has risen by about 1.50%. When compared to increases of three to five percent that occurred on numerous occasions over the last 30 years, it’s hard to blame them for barely raising an eyebrow at a mere 1.50%. What these so-called experts fail to grasp, is that the amount of financial and economic leverage has grown rapidly over the last thirty years.
As such, it now takes a much smaller increase in interest rates to slow economic growth, raise credit concerns, reduce the ability to add further debt and generate financial market volatility.
The 1.50% increase in interest rates over the last two years is possibly equal to or even more significant than those larger increases of years past. In this article, I look back at how the economy and assets performed in those eras. I then summarize potential economic and market outcomes that are dependent on the resolution of current yields against their resistance levels.
Technical Analysis
In October 1981, following a period of strong inflation and dollar weakness, the yield on the ten-year U.S. Treasury note peaked at 15.84%. Since those daunting days, bond yields have gradually declined to the lowest levels in U.S. recorded history. To put the duration of this move in context, no investment professional under the age of 60 has worked in a true secular bond bear market.
During this long and durable decline in interest rates, there were periods were interest rates moved counter to the trend. In some cases, moves higher in yield were sudden and the effects on the economy and financial markets were meaningful. In my article “1987”, I showed how an increase of over 3.00% on the ten-year Treasury note over a ten month period was a leading cause of Black Monday, the largest one-day loss in U.S. stock market history.
Interestingly, historical short-term peaks in yield have been technically related. When graphed, the peaks and troughs can be neatly connected with a linear downward sloping channel, which has proven reliable support and resistance for yields.
The graphs below show the decline in yields and the respective channels for Two, Five and Ten-year Treasury notes. Our focus is on the resistance yield line, the upper line of the channels.
The composite graph below shows all three securities together with labeled boxes that correspond to commentary beneath the chart for each era.
Currently, all three Treasury note yields are perched up against their technical resistance lines. From this, we can conclude there are three likely scenarios.
- Resistance holds and yields decline sharply as they have done in the past
- Yields break above the trend line, marking the end to the 35-year-old bond bull market
- Yields meander with no regard for the dependable technical guideposts that have worked so well in the past.
Bond Investors and holders of other financial assets should pay close attention to this dynamic and be prepared. The following summarizes expectations for the three scenarios listed above.
- Resistance holds and yields decline sharply– If yields decline sharply as they have previously, it will likely be due to slowing economic activity and/or a flight to quality. A flight to quality, in which investors seek the safety of U.S. Treasuries, is typically the result of financial market volatility and/or a geopolitical situation. Given extreme equity valuations, investors should be prepared for significant stock price declines, as was witnessed three of the past four times the resistance level was reached and held.
- Yields break through the trend line– If resistance does not contain yields, it is quite likely that technical traders will take the cue and accelerate bond selling and shorting, leading to the possibility of a sharper increase in yields. This condition could be further aggravated by poor supply and demand dynamics for Treasury securities as noted in Deficits Do Matter. Given the amount of economic and financial leverage outstanding as well as the economy’s dependence on low interest rates, we expect growth will suffer mightily if yields rise aggressively. In turn, this will dampen corporate earnings and ultimately weigh on stock prices.
- Yields meander– This is the Goldilocks scenario for the economy and the financial markets. This scenario rests on a healthy equilibrium in the economy where growth is moderate, and inflation remains tame. Given that current interest rates are not high enough to significantly harm economic growth or hinder government borrowing, we suspect that the massive fiscal stimulus along with decent global growth will keep GDP propped up. We also suspect that, despite high valuations, stocks would likely be stable to higher.
Summary
Of the three possible scenarios, rates meandering is the least likely.
The historical interest rate events discussed above offer hints that allow investors to better assess the possibility of each scenario but, unfortunately, with unusually poor clarity. The reason is our starting point on this occasion is without historical precedence. We are at the lowest levels of interest rates in the history of mankind and the highest amount of leverage. To make matters worse, central banks don’t understand the effects of their recent interventions.
The economy has just received a large fiscal boost via the tax cut and new budget agreement which will be accompanied by large deficits for years to come. The growth impulse over the next several quarters will be meaningful, but there are a variety of offsets. First, the Fed is hiking rates and removing unconventional stimulus (QE).
Second, tariffs intended to level the trade paying field hold an uncertain outcome but run the risk of stoking both inflation and the ire of foreign trading partners. Geopolitical risks remain elevated, and those come with the small but real threat of an exogenous shock to the economy. Synchronous global growth appears to be forming, but recent data from China and Europe imply economic deceleration. Uncertainties remain quite high and are not being accounted for in the price of risky assets.
The one sure thing I would bet on for the remainder of 2018 is more volatility in every asset class, including interest rates. As a direct input into the pricing of all financial securities, higher volatility tends to imply lower stock prices and wider credit spreads on high-yield debt. As such, bond and stock investors should equip themselves to deal with volatile markets. The reprieve of the moment is a gift and should humbly be viewed as such.
