How High Will Interest Rates Go?
The question I get asked the most is why interest rates are rising despite my view that they should be falling. Many analysts and stock market professionals are saying interest rates will go much higher as the secular bond bull market, which began in the early 1980’s, ends. It’s easy to take the side of the experts who believe interest rates are going to continue rising.
There are lots of reasons experts are saying interest rates are headed much higher. Some say inflation is taking hold, while others point to the economic data which suggests the economy is booming. The consensus view is that rates are going to only go higher for many decades to come. Technical traders have even weighed in, showing chart patterns indicating 30-year Treasury yields are headed from 3.4%, all the way to 4.5-6%! Yet a small number of people, such as myself, say the experts are wrong.
The view of rising inflation and interest rates began after President Trump won the election. This view came from the Carter and Reagan presidencies when inflation was out of control. For some reason, Americans equate inflation with deficit spending. This view could not be further from the truth.
In the early years of our great nation, money-printing inflation was a problem as it was easy to print more money to pay for wars. Printing money led to repeated currency crises, so the Constitution was later amended to prohibit the Federal government from printing money. Given politicians seem to spend money without any regard, this was probably a good idea.
The Federal government can only borrow money from those who hold U.S. dollars. The government mostly borrows from large domestic and foreign investors, pension funds, financial institutions (banks, insurance companies, etc.), sovereign wealth funds, and foreign central banks, who have excess U.S. dollars. Borrowing dollars from those who have dollars does not lead to the creation of new dollars, therefore government deficits aren’t inflationary.
This inflationary view was accelerated when the Federal Reserve announced they would begin unwinding their balance sheet of U.S. Treasury bonds and Mortgage-Backed Securities starting in October 2017. Experts believe the Fed’s Quantitative Easing programs caused interest rates to fall, and therefore they should now rise. This view is partially correct. The intent of QE 1-3 was to lower short-term interest rates, and therefore the opposite of QE should cause short-term interest rates to rise. So far, short-term interest rates have risen, and they should continue to do so as long as the Fed continues to tighten monetary policy.
Experts believe that if short-term rates are rising, so should long-term rates. This view is incorrect. During QE 1-3, long-term interest rates rose, and therefore the opposite should be occurring now. The reason long-term interest rates rose during QE 1-3 is because there was a demand for long-term loans. Long-term loans, such as real estate loans, must be backed by long-term assets. It just so happens, long-term U.S. Treasury bonds are the perfect asset to back long-term loans because they are considered a reserve asset.
A reserve asset is an asset that can be readily converted to U.S. dollars, which a U.S. Treasury bond can. The U.S. Treasury bond market is the deepest and most liquid market in the entire world, making them ideal for banks to hold against long-term loans. The reason long-term interest rates rose during QE 1-3 is because the Fed was buying up all the long-term Treasuries they could find. To attract money to back long-term loans, long-term interest rates rose. As the Fed tightens monetary policy and unwinds their balance sheet, long-term interest rates should be falling.
Yet others point to the robust Trump economy and the over-valuated stock market as a reason interest rates should be rising across the board. Of all arguments, this has the most logic. After all, the Constitution prevents the Federal government from creating inflation and the Federal Reserve Act of 1937 prevents the Fed from creating inflation. It is the banking system that creates inflation as borrowed money is deposited and reborrowed from one bank to the next. During economic expansions, money is changing hands, which creates inflation.
It’s easy to determine if the money supply is expanding and inflationary pressures are building. The St. Louis Federal Reserve maintains a public database full of economic data. The Money Supply has been decelerating since 2016 and is growing at just under 4%. Historically, when the Money Supply falls below 3.7%, recessions and depressions are prevalent. The Monetary Base, or the total amount of money in the economy, has dropped double-digits since 2016, and Excess Reserve, held at banks, are also down double-digits over the same period. Based on the data, the money supply isn’t expanding at a rate that would lead to inflation or higher interest rates.
Other factors, such as the Money Multiplier, which indicates how many times a new dollar multiplies in the financial system before dying, is at four, whereas its all-time high was at 12 back in the mid-1980’s. Even the number of commercial banks, which is critical in the multiplication of money in our system, has dramatically fallen from a peak of over 14,000 in the mid-1980’s to 4,805 as of August 2018. All the inflation generating mechanisms in our financial system are broken to the point where they cannot create high rates of inflation or high-interest rates.
Despite the facts, this hasn’t stopped stock market participants and speculators from taking the largest bet in history against the Treasury bond market. These bond bear bets pay off if interest rates spike. At the same time, there is the largest bet in history for Treasury bonds. Commercial Hedgers, who are also known as the Smart Money, have bet against the Speculators every step of the way. The Smart Money has been buying a record amount of Treasury bonds since the election on the belief interest rates will go much lower.
It’s rather easy to tell if the Smart Money or the Speculators will be right, and the effect higher interest rates are having on the economy. The interest-sensitive financial data should show if the economy is absorbing higher interest rates without much consequence or if higher interest rates are slowing lending growth. The purpose of higher interest rates is to slow down the rate of lending growth, which is the money generating mechanism in our economy.
Ever since the Fed began raising interest rates in December 2015, and subsequently began unwinding their balance sheet in October 2017, lending growth has decelerated. Commercial lending, or business lending, has rapidly decelerated and nearly contracted in December 2017. The growth rate of margin debt, or loans used to buy stocks, has nearly gone to zero. Automobile loans have been decelerating. Home lending growth, a big money generator in our economy, is also quickly decelerating. Businesses and consumers are responding to higher interest rates by borrowing less.
The data is clearly showing the economy cannot continue to absorb higher interest rates. Should interest rates continue to rise, the deceleration in lending growth will increase until lending contracts. As the money-generators in our economy slow, so does economic growth.
Famed economist Milton Friedman showed that in periods of monetary decelerations, long-term interest rates should fall. The economic data is consistent with his view. He also noted that long-term interest rates can have brief periods where they rise during monetary decelerations, but ultimately interest rates will fall.
Despite the facts, this hasn’t stopped the speculators from betting against the Treasury bond market. This bet against the Treasury market hasn’t been smooth sailing for the speculators. They have committed a record amount of money to this bet as they face two massive headwinds from the U.S. Treasury and the Federal Reserve, in addition to the Smart Money.
Contrary to popular belief, government deficits are deflationary. The more money a government borrows, the less money the public has available to invest in money-generating activities. This is why developed countries that run large deficits have persistently low-interest rates. The United States is expected to borrow 60% more in the second half of 2018 then we did in the second half of 2017. Our increasing deficits are deflationary, which is putting downward pressure on bond yields as the speculators continue to try to push yields higher.
The other headwind is the Federal Reserve. I have written extensively and provided charts showing that when the Fed sells off its bond portfolio, as they are doing now, it leads to lower long-term bond yields. Starting with this month, the Fed is raising its monthly cap to $50 billion of U.S. Treasury and Mortgage-Back Securities they can unwind. The Fed attempts each month to reach the cap, although there aren’t always enough maturing bonds to cap out their unwinding.
The evidence these headwinds are causing problems for the speculators is the fact that 10-year Treasury yields have barely risen over 3% since the election despite a record speculative short position. It is worth noting, this speculative short position is about 2.5 times larger than the previous record. Between the Smart Money, the U.S. Treasury and the Federal Reserve, the speculators must commit an ever-increasing amount of money just to hold their position.
Occasionally the speculators get a short-term victory, as they did two weeks ago, but their victories are short-lived. Every month there are at least two weeks of large Treasury auctions, once a month the Fed unwinds their balance sheet, and so far, every quarter the Fed raises rates. This is all in addition to the Smart Money who continues to buy Treasuries.
Emotionally, times like this can be difficult for bond investors. There is a feeling they should join the speculative crowd, then rebuy back later. This can be a dangerous move because when interest rates fall, they plummet. Those who sell their bonds hoping to rebuy when yields fall, always miss the initial move down in yields. Unfortunately, it is a waiting game, but one that should pay off big for bondholders as the economy is clearly showing it cannot handle higher interest rates.
When the payoff comes for bondholders, it will be big. Few people understand there is $1 trillion invested in direct volatility-controlled products and $2 trillion in indirect volatility-controlled products, both which shift their equity exposure from stocks to bonds when volatility rises.
Currently, most of these investments are 100% allocated to stocks, but when the shift occurs, they can move to a 100% bond allocation. When the next recession hits and volatility spikes, these investments will drive interest rates to the floor. For those who believe we are closer to a recession than the next economic boom, the payday in Treasuries will be rather lucrative.
It is possible interest rates will hit 4.5-6% as the speculators believe? Yes, but not today or anytime soon. Should yields continue rising, they will end up triggering a recession that will lead to lower bond yields. I believe 10-year Treasury yields will sooner hit 0% than 4.5%. For yields to rise that high, the Fed will have to directly monetize money, which they legally cannot do. Until Congress repeals or modifies the Federal Reserve Act of 1937, Treasury yields will fall with every economic downturn.
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Daily Market Briefs
- Thoughts from the Weekend
- What happened to the stock market on Monday?
U.S. stocks started the day higher as Asian equities were down, led by China, where stocks were down 3.7% after the Chinese stock market has been closed for Golden Week. European stocks followed suit as the European Central Bank rejected Italy’s budget proposal. Not to be outdone, European bank stocks fell to their 18-month low. Oil was rather flat in early trading, despite news that China has ceased all imports of U.S. oil.
After dropping below its 50-day moving average, the S&P 500 rallied to close above it. The Nasdaq-100 slipped below its 100-day moving average, but buyers stepped in to push it back over. The Russell 2000 dropped below its 200-day moving average but closed above it. U.S. investors continue to buy every drop in the market as if the U.S. economy is immune to the weakness from the rest of the world.
The reason stocks bounced today was due to volatility. The VIX volatility index came right up to the level where back in February that caused a huge spike in volatility. Should that happen again, stocks will aggressively sell off. There are many highly-leveraged market participants who do not want to see that happen yet, so they were forced to buy stocks and short volatility.
The bond market was closed today for Columbus Day but should reopen tonight with the Japanese stock market. There are eight Treasury auctions scheduled for the next three days, which should further drain liquidity from the market. These auctions should also provide some direction for the bond market going forward.
Physical gold was dumped in overnight trading, sending gold down to $1,190/oz. The gold and silver mining stocks reacted accordingly but recovered those losses.
Agricultural commodities continue to move higher on low volume which is a sign of strength. Should they continue to rise, short sellers should get flushed out. Higher agricultural commodity prices are coming.
- What happened to the stock market on Tuesday?
Outside of the tech-heavy Nasdaq-100, most sectors closed in the red today. Asian stocks were down big and European stocks were up slightly.
The S&P 500 bounced off its February highs and managed to close just over its 50-day moving average. The Nasdaq-100 bounced off its 100-day moving average and the Russell 2000 bounced off its 200-day moving average. All major indices fell going into the closing bell.
Treasury yields fell as buyers came in over the past few days to mop up the heavy selling. I expect yields to fall and bond prices to rally. Treasuries are heavily oversold and there are no indications inflation is about to burst higher.
This week $230 billion of new debt is being auctioned off by the U.S. Treasury. Treasury bears believe higher deficits should drive yields higher, but if that were true, yields should already be double-digits. After all, the United States is the largest debtor nation in the history of the world.
President Trump said today that he doesn’t like what the Fed is doing, although he is going to stay out of their business. He is a self-proclaimed fan of low-interest rates and wishes the Fed would back off. Clearly, President Trump is aware the Fed is going to tighten the economy into a recession. President Trump’s remarks should be seen as the foundation for blaming the Fed for the next recession, which will be accurate.
Physical gold was unable to make much of a move higher today. The large gold and silver miners continue to see a wave of continued selling as both took losses today. The mining bears appear to have the upper hand for the moment. Once all the sellers have exhausted themselves, the bulls will have their day.
Tomorrow all eyes will be on the API oil inventory data, the 3-year Treasury auction and the reopening of last month’s 10-year Treasury auction.
- What happened to the stock market on Wednesday?
The computers started selling. I have been warning for the past couple of years that this market has been traded mostly by computers, with some experts indicating that 90% of all trades are computer driven. Since these machines have taken over trading, we’ve never seen them sell. Until now.
According to Nomura’s cross-asset quant division, the recent selling has to do with CTAs delivering their S&P 500 futures position from 97% to 77%. Nomura’s team indicates these computer trading algorithms are likely to drop their allocation to the S&P 500 to 57% should index futures close below 2,895, which they did. Today’s move down has the potential to spark a feedback loop which could cause other computer algorithms to sell stocks and buy bonds.
Treasury yields nudged higher as the market believes higher U.S. debt issuance should lead to higher interest rates. Interest rates are a function of lending demand, which according to the weekly Mortgage Bankers Association mortgage application survey, shows continued weakened lending demand.
I mentioned yesterday that $230 billion of Treasuries were scheduled to be auctioned this week, but I should have stated that is the amount for the entire month of October. Today’s 3-year Treasury auction saw tepid demand and today’s 10-year Treasury auction saw strong foreign demand with foreigners snapping up 64.5% of the auction. Direct bidders were largely absent, with securities dealers forced to accept the rest of the auction. Dealers don’t like to lose money, so look for the bond market to turn the other direction as dealers look to unload their inventory.
Computer algorithms sold off early which likely triggered margin calls, forcing more investors to sell. This was not a massive sell-off, as indicated by the trading volume. Today’s move down was more a function of volatility, which spiked over 40%. I expect the risk-parity algorithms to start selling tonight, which should lead to more selling tomorrow. Selling into an illiquid market is a quick way to bring stocks down.
- What happened to the stock market on Thursday?
Foreign stocks were hammered last night as they followed U.S. stocks down. The computerized trading programs, or CTAs, went from a position of “max long” on the S&P 500 to “43% long” in one week, which equates to selling $88 billion of S&P 500 futures. With corporations unable to buy stocks during the blackout period before earnings, stocks are finding it difficult to rise with the largest buyer on a forced vacation.
As I suggested yesterday, risk-parity funds did sell last night to the tune of $600 million of S&P 500 positions. This is a relatively small amount that can increase as volatility increases. The CTAs won’t do any more selling unless the S&P 500 falls below 2,710, where they will drop to a “9% long” position by selling $57 billion of S&P 500 futures.
Treasury yields dipped in overnight trading as analysts indicated the ‘flight to safety’ trade of Treasuries is no longer valid. Today’s 30-year Treasury auction saw very strong foreign interest, indicating foreigners do not believe in the U.S. inflation narrative. The safety trade hasn’t kicked in because nobody believes this market sell-off will last more than a day or two. Once you realize the largest buyer is on vacation, there is more risk to the downside than upside.
The Core Consumer Price Index came in softer than expected but at +2.3% YoY is still higher than the Fed’s 2% target. Inflation is starting to roll over as the growth rate in the money supply continues to decelerate. With the unemployment rate at the lowest level since 1969, the question remains, how is inflation going to continue rising from here? The Fed’s models show an inverse correlation between unemployment and inflation. With unemployment so low, the odds are we are closer to peak inflation than we are to a boom in inflation, especially as the Fed continues to destroy money through their balance sheet unwinding.
Stocks closed again in the red, with the S&P 500 closing just over the critical 2,719 level where the CTAs will enter another round of selling. Look for further weakness as margin calls are likely occurring for those who borrowed money to buy stocks and are now upside down on their margin limits. Those receiving margin calls have 24 hours to either add cash to their accounts or to place a sell order. Selling begets selling, especially in an overvalued, illiquid market!
Treasuries were a safe haven today as investors started moving money into bonds. Risk-parity portfolios should enter another round of selling tonight as the VIX volatility index closed +8% higher.
Physical gold and the miners staged a big one-day move making it look like the bottom is set. Buying an initial move off a bottoming pattern can be a gamble, as sellers may look to sell into the strength. The gold miners are a long way from a technical breakout, but their first move over their 50-day moving average is key. Hopefully, we are on the cusp of the bottom I’ve been looking for.
- What happened to the stock market on Friday?
The S&P 500, Nasdaq-100, and Dow Jones Industrial Average all closed below their 200-day moving averages yesterday. The two-hundred-day moving average is the average price over the past two hundred days. When a security falls below that level, sellers tend to come out as it is a potential indicator of price weakness.
In a Bull market, the 200-day moving average is an opportunity to buy low. In overnight trade, investors bought after close since the general opinion is this market is headed much higher. After opening above their 200-day moving averages, both the S&P 500 and DJIA briefly fell back below. By the close, all three indices were back above their 200-day moving averages – a sign of relief for the equity Bulls.
Without corporations buying their stocks back, the largest marginal buyer remains on vacation. While days like today can look like a big opportunity to buy, one has to asses the overall weakness of this past week. When factoring weaker than expected earnings for the third quarter, this is a good chance there may be further selling before corporations can resume buying.
Treasury yields tried to move higher, and while they closed higher on the day, they traded down. Higher Treasury yields continue to attract buyers.
Physical gold has attempted to break out but just hasn’t been able to do it. The gold miners are in the same situation.
Agricultural commodities continue to push towards their 100-day moving average, which will likely be an area of resistance. Look for sellers to return and prices to fall a bit before the rally resumes. For the time being, a bottom appears to be in place.
Should the market continue to sell off, which I believe it has the potential to, it will create an excellent short-term buying opportunity. With corporate share buybacks expected to resume sometime around the midterms, it is possible the market will rally towards the end of the year. Being able to buy before the computers start buying, is a smart move if you know how everyone is positioned.
Portfolio Shield™ Update –
The printing issue has been resolved and the October 2018 Investment Detail is linked below.