Weekly Economic Update 02-02-2018

Rising Bond Yields Crash Stock Markets

Investors have been selling bonds to buy stocks this past year as they anticipate ever-increasing stock prices and higher inflation. It is important to understand that rising bond yields triggered the dot-com bust in 2000 and led to the unraveling of the mortgage bubble in 2008. The Federal Reserve has caused every expansion by easing monetary policy and has also caused every recession by raising interest rates past their “natural interest-rate” interest-rate” level. As the Fed continues to tighten and the money supply continues to fall, liquidity will dry up and cause bond yields to fall. The year 2011 is a perfect example of when 10-year Treasury yields fell from 3% to 1.7% in a short period of time. Rising bond yields are a sign that the end of this cycle is much closer than most investors realize.

The reason we have boom and bust cycles is due to the Federal Reserve’s manipulation of the money supply and interest rates. By keeping interest rates low for an extended period, the Fed encourages corporations and consumers to take on riskier investments and more debt. It also helps alleviate the current problem by allowing existing loans to be refinanced at lower rates. This is precisely why interest rates have fallen for the past 35 years. With each successive crisis, the Fed is forced to lower rates to fix the latest problem that it created.

For some reason, investors believe that this time is different – that stocks will continue to rise indefinitely, and interest rates will rise to offset inflation. As I have discussed in the past, bond yields are a function of supply and demand, as well as the number of Treasury reserves held at Federal Reserve Banks. In the absence of an increase in the debt ceiling, the Treasury cannot issue new long-term bonds which are driving yields higher, for now. Even as yields rise, buyers are stepping in and Treasury auctions have been strong, which shows there is demand for Treasuries.

Soon pension funds and institutional money managers will also have to buy bonds as their investment policies require them to maintain a certain allocation to both stocks and bonds. With equities rising faster than bonds, these managers will be forced to sell equities to buy bonds. Just last week a report came out that indicated pension funds would need to sell $12 billion of equities to buy bonds in the near future. Banks will also have to start buying Treasuries as the unwinding of Quantitative Easing will cause bank reserves to fall by $500 billion by 2021. The best option for banks to replace these reserves is by buying U.S. Treasuries because they have a zero percent risk weight. Having an asset with a zero risk rate is an attractive option for banks who need to reduce the overall risk-weight of their asset pool.

The real reason investors are complacent is because they believe the Federal Reserve can keep asset prices from falling, even though the Fed has never been able to keep asset prices from falling during any recession. The problem always begins with higher interest rates, as borrowers struggle to service their debts. As borrowers struggle, banks cut back on their lending, which causes asset prices to fall. Without the ability to access more credit, buying interest dries up throughout the economy which leads to a drop in asset prices.

The root of the problem is always the same – fiat currency. Fiat currency is any form of money that isn’t backed by a hard asset, which is commonly gold. When a currency isn’t backed by a physical asset, a government can print an unlimited amount of paper without any recourse. As more money is created out of ‘thin air,’ it finds its way into unproductive projects, it distorts interest rates, lowers the savings rate and in general, causes financial markets to function abnormally. We now live in a world where negative interest rates exist, even though the concept doesn’t make sense to most people.

The longer-term issue with fiat currencies is the never-ending level of debt. Following the Great Financial Crisis of 2008-09, the Fed lowered interest rates to help people and corporations deleverage. The deleveraging failed because, as the data shows, there is more debt now than there was before the Great Financial Crisis! Instead, we are caught in a debt trap where it takes an increasing amount of debt to generate a unit of economic growth. And this isn’t just happening in America, it’s happening all over the world as foreign central banks try to print their way to prosperity.

At some point in every money printing scheme, central bankers become concerned that they are going to create too much inflation. The real fear is that people will no longer want paper currencies and demand a currency that holds its value. To keep the public addicted to the fiat money scheme, central bankers raise interest rates and use other monetary policy tools to reduce the amount of money in the economy. The immediate effect of this is higher interest rates. As interest rates rise, the economy can still boom. But at some point, interest rates rise above the ‘natural interest-rate’ level, which causes an economy to come to an immediate halt.

The challenge is finding where the natural interest-rate level is, but nobody knows. The Fed and Wall Street will continue to push interest rates up until the economy breaks. Since nobody knows where this breaking point is, the economy continues to boom up until the moment it goes bust. An example of this kind of failure can be taken from the failure of Lehman Brothers – nobody saw it coming. Central bankers can keep a boom going for prolonged periods by keeping interest rates artificially low and expanding the money supply, which is exactly what the Yellen-led Federal Reserve did during her tenure. And because of that, we have huge imbalances throughout our economy.

These imbalances can’t continue forever. Money printing schemes end in one of two ways: either there is so much money printed that it rapidly loses its purchasing power or by raising interest rates above the natural interest rate. The natural interest rate is always lower than the rate of interest of the prior cycle, which is why interest rates never rise above the highest-level set during the prior cycle. This also explains why for the past 35 years interest rates have gradually fallen. Any attempt to return interest rates to the level of the prior cycle has always led to an economic collapse. Once the economy fails, central bankers rush to the rescue with lower interest rates and more printed money – and the cycle begins again. As I have mentioned in prior updates, an economic crash is not a matter of if, but a matter of when. It is inevitable, regardless if people want to accept it or not. Ludwig von Mises (1881-1973), who the father of Austrian Economic Theory, says this about money printing schemes:

“There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

The next economic crash is likely to be bigger than the last because there is more debt and there has been more money printed than any prior cycle. Many forget that the Great Financial Crisis was caused by too much debt and today we have accrued even more debt this time around. The length of the money printing cycle also matters. The longer the Fed keeps the cycle going, the greater the ensuing collapse. And this is now the second longest expansionary credit cycle in history, which suggests the end is much closer than anyone believes.

Since the end of most money printing schemes comes with rising interest rates, we know we are close to the end. Even though the Fed has been slow to raise interest rates, Wall Street is encouraging investors to dump their bonds to drive interest rates up. The public believes this is a wise move as bonds lose value against inflation, but the big money knows that higher rates will break the economy.

The public doesn’t realize that Wall Street is manipulating them into causing a crash by selling their bonds. Interest rates are slowly rising because Wall Street is buying the same bonds the public is selling. The only difference is that Wall Street is aware that we may be as little as a 0.1% increase in bond yields away from a crash and they want to buy as many of those bonds as possible because interest rates always fall during recessions.

The reason this time appears different than other times is because of the actions by the Federal Reserve. While the Fed was raising the Federal Funds rate, they were also continuing to reinvest the dividends from their $4 trillion bond portfolio. As it would turn out, using the dividends to buy more bonds had a much greater effect on asset prices than raising the Federal Funds rate. It also didn’t hurt that the Fed was quietly propping up the stock market every time it started to fall.

But that party is coming to an end, as the Fed is now slowly selling off their bond portfolio. As they sell bonds, asset prices should fall, and volatility should return to the stock market. Next week we will have a new Fed Chairman, who hasn’t been a big proponent of Quantitative Easing. We will soon find out if he will take a more aggressive stance towards tightening the money supply or maintain the dovish status quo.

For those risking their hard-earned retirement savings in the stock market, a part of me hopes I’m wrong. History has shown that not one money printing scheme in the history of the world has ever worked, but it hasn’t stopped mankind from trying. If I am right and this market cycle goes bust, it will leave many retirees in a dire financial situation with no hope of recovery.

Q&A with Steve – Your Questions Answered

  1. You seem very convicted that U.S. Treasury bonds are a good investment. Why?

The Fed is unwinding their $4 trillion balance sheet which caused long-term bond yields to rise. As they unwind, long-term yields should fall. The U.S. Treasury is going to have to raise a huge amount of money to pay for the deficits, which will have the effect of draining liquidity and lowering long-term bond yields. Plus, the government cannot afford higher interest payments on our debt, so I suspect yields will need to fall. And last, we have a new Fed Chairman taking the reins next week who isn’t a big fan of the Fed buying bonds. If he increases the rate of tightening, which he can, it will bring yields down.

  1. How low do you think yields will go?

I expect 10-year Treasury yields to fall to 0-0.5% by the bottom of the next recession. It wouldn’t surprise me if they go negative.

  1. But what if yields keep rising?

At some point they will cause havoc with stocks and yields will rapidly fall, just as they have for the past 35 years. There is no reason to think this time is different, except we have more debt and leverage than ever before. When the debt and leverage unwind, lending demand and interest rates will plummet.

  1. But there’s all this talk of inflation. Shouldn’t yields rise to offset that?

Yes, but it depends on the type of inflation. If demand is outpacing supply, then yields should rise. That is a good kind of inflation because it suggests that wages are increasing along with demand for goods and services. This is not the type of inflation we are currently seeing.

Then there is inflation from too much money printing. Given the Fed is tightening, unwinding their balance sheet, and the money supply is falling, this type of inflation is transitory. When all of the debt and leverage unwinds, it will cause the money supply to rapidly fall. This explains a little of what we are seeing.

Then there is inflation due to lack of supply. This is when there is insufficient bank or Treasury deposits to meet demand. When this happens, yields rise to attract capital. This is exactly the type of inflation we are seeing now. When capital leaves risk assets for safe assets, it will cause risk assets to fall in value. As risk assets fall, investors will flee to safe assets, which will cause bond prices to rise and bond yields to fall.

  1. Why not sell and rebuy later?

Because yields move very quickly when there is a risk-off event. If you recall the evening of the Presidential election when the Dow futures dropped over 600 points – bond yields plummeted. Knowing this is the second or most overvalued market in history, with the Fed unwinding, the Fed tightening and Congress likely to raise the debt ceiling soon, there could be a rapid reversal at any time. I’d just assume ride that reversal. Unless things really are different this time, but so far there is not an indication that this is. Although the public thinks it’s different this time, the public thinks that at every market peak.

  1. Could this trigger the feedback loop you mentioned?

Yes, and I suspect we will see that in the stock market on Monday. Risk-parity and volatility-controlled products buy stocks and sell bonds when volatility is low and sell stocks and buy bonds when volatility rises. As of a few days ago, these products were 100%+ allocated to equities – yes, some of them take a leveraged position. They are already starting to sell stocks to buy bonds, and if volatility rises high enough, they could go to a 100% bond allocation. There’s about $2 trillion in these products. Talk about a huge tail-wind for bonds!

  1. Why are bonds selling off then?

The public is selling bonds to buy stocks. However, I think their opinion on this will be changing soon if the market continues to drop. In every cycle the public has turned to bonds for safety, and this time is unlikely to be different.

Video Topic of the Week – New Prototype Algorithm!

This week I want to share with you how the algorithm works and how I see it being used in our future. It’s really cool!!

Chart of the Week – Savings Rate Continues to Fall

I have several charts on the savings rate, which one analyst says doesn’t matter! I’ll let you be the judge of that.

Portfolio Shield™ Update – Breakthrough!!

A few weeks or so ago I mentioned I was working on an algorithm that would track a major moving average. The idea is that when the moving average rolls over to the downside that the algorithm would recommend a sell and when it turns up from a bottom that it would recommend a buy.

I may have also mentioned that this was a seemingly impossible challenge. Several of you reached out to encourage me – I greatly appreciate that.

I have some exciting news to share! The other night I figured it out. The following day I wrote and tested the algorithm, and it worked better than I thought it would.

I applied the algorithm against the S&P 500 and ran a 15+ year backtest. The results are very impressive. One of the buttons below is labeled “Portfolio Shield Prototype” where you can see the Morningstar® Investment Detail report for the backtest.

This isn’t the final version as I’m still running tests, but when you see the results, I think you’ll be equally amazed. The back-test show that over the past ten years the algorithm would have doubled the total return of the S&P 500 with a beta normally associated with a low-risk portfolio. That is impressive!

The plan is to apply the algorithm to a diverse set of sector funds, equity funds, bond funds and commodity funds. From there I intend to build a model that will review each of those investments daily to identify the ones that the algorithm shows have a high probability of rising in the future. The portfolio will be made up of only those choices that the algorithm believes are likely to go up.

Once it is done, there will be nothing like it in existence. The idea is that it will seek out investments that are trending up along their major moving average with the hope that the portfolio should increase in value most of the time.

I will keep you posted as I progress with this, but in the meantime, I hope you will check out the Prototype report.

Weekly Broad Market / Economy Commentary

Volatility is back. Former Fed Chairman Alan Greenspan has said we are in a bubble, and yet, retail investors are dumping money into stocks at a record pace. It is important to understand that the public buys the most at the top and least at the bottom.

After a year of trying to convince investors that the tax cuts will drive stocks higher, that we’re going to see a blow-off top where stocks rise 50% or more and that inflation is going to rip their bond investments to shreds, investors have bought into the narrative. Since the market has risen following every small drop in prices, the public sees this week’s drop as an opportunity to buy before prices go straight up. The incoming fund flows show that the public is buying in big numbers, but not big enough to cause a surge in prices.

That is because the big money is selling. This is evident in the daily trading volumes. Any time you see lots of volume, or shares trading hands, and a small price movement, you can bet there is selling going on. And for good reason, because the big money knows the market is overvalued – they’ve just been waiting for the public to finally believe that this time is different.

Even though bond yields are rising as the public unloads them, bond volumes are high and price movements aren’t that big, which is an indication that someone is buying bonds. The reason the big money wants to buy bonds is because they know the cycle is about to shift.

Pension funds and instructional money managers will need to sell at least $12 billion of equities to rebalance their portfolios, which far exceeds the amount the public is buying. That alone will cause stock prices to fall.

In addition, the U.S. Treasury is starting to raise funds and when the debt ceiling is raised, the Treasury will sell a large number of bonds to raise cash. Those bonds will get sold and that will cause a huge drain on liquidity and asset prices.

As we watch every week, the Fed’s balance sheet unwind is moving along slowly and is about to start a larger downward slide. As the Fed unwinds their balance sheet, asset prices and interest rates should fall.

If you were the big money and you saw these developments happening, then you’d want to sell your equities to buy bonds. And that’s exactly what they are doing. Plus, they know that once yields rise enough, something will start to break. And with the public buying stocks at record levels, the big money is sees this as a huge opportunity to make money.

For those who don’t believe the stock market is overvalued, the S&P 500 has risen 39% from its prior peak while profits are only up 6%.

If the savings rate hadn’t fallen below 3%, personal consumption expenditures (PCE) would have been 1.9% instead of 2.5%. This tells us that consumers are draining their savings to keep the economy running – a trend that can’t last.

GDP growth for 2017 came in at an annualized rate of 2.3%, which is about where it has been for the past 8 years.

S&P 500 has a forward price-to-earnings multiple of 18.4x, which has only been higher 10% of the time.

Based on the price-to-sales ratio, the stock market has only been higher 4% of the time.

On a price-to-book basis, which is at 3.4x, the market has only been higher 7% of the time.

Enterprise value (EV) divided by earnings before interest, taxes, and amortization (EBITA) is at 14x, which has only been higher 2% of the time.

Price-to-cash flow is at 15.4x, which has only been higher 13% of the time.

This isn’t a market for long-term investors.