Charts, Economy, Investing, Posts

Don’t Believe The Hype Of Rising Interest Rates

“Best investments for a rising rate environment” “The coming crash in the bond market” “How to prepare for an interest rate spike”

I’m seeing these kinds of headlines and stories everywhere. Everyone and their mom is expecting long-term interest rates to rise now that the Fed is tapering its bond buying programs. (Actually, interest in the term “bond market crash” peaked last Summer, ironically right at the time bonds bottomed in price. See chart below.)

Screen Shot 2014-03-26 at 2.13.00 PMI have a couple of problems with this line of thinking. First, although it seems like reducing demand for a security (i.e. tapering QE) would result in a drop in price, when you really think about how quantitative easing works this makes no sense. Second, the market is telling us this makes no sense. Let me explain.

To the first point, quantitative easing has been effective in supporting the economy through the wealth effect. It has encouraged investors to shun low-risk, low-yielding investments for higher-risk investments (if you can even classify them as investments). This has resulted in a surge in the prices of stocks, corporate bonds, real estate, etc. over the past five years with a greater effect on the riskiest categories within those asset classes: money-losing tech and biotech stocks, junk bonds and leveraged loans, etc. As a result investors feel wealthier and thus they spend more. They’re happy and the Fed’s happy because the economy’s happy.

But now that all of this is ending what should we reasonably expect as a result? To my mind, if QE is an inflationary force, intended to boost the economy, its removal can only have a net deflationary effect on the economy. For those unaware, inflation is bearish for bonds (rising rates = lower bond prices) and deflation is bullish (lower rates = higher bond prices).

To the second point, this isn’t just my personal opinion. This is exactly what the market is telling us. I’ve shared this chart before. It shows the history of quantitative easing and how various assets have been affected:


At the end of the prior QE programs it’s plain to see that not only did bonds fail to “crash” they actually surged in price. I believe investors fled to bonds in these two prior circumstances for two reasons: First, many traders were heavily short bonds anticipating a fall in price as the Fed ended purchases:


All these shorts were forced to cover when… Second, the economy showed brief signs of weakness, aka deflation, which sent bond prices higher/rates lower inspiring the Fed to take up QE yet again. (This is probably what Richard Koo means when he says the Fed is in a “QE trap.” They can’t end their bond purchases without harming the economy.)

Notice that traders are once again heavily short the long bond. In the past this sort of positioning has led to strong moves higher as traders cover their shorts.

Now the Fed isn’t technically ending QE right now; it’s merely tapering it’s purchases. I think this is why this trade has been a bit messier than those QE end trades of the past few years. Bonds have risen but they haven’t quite “surged” as they have in the past. Still, Janet Yellen has said that the Fed intends to continue tapering until the bond buying is ceased entirely so the result should eventually be the same. (Time will tell if they are actually capable of removing this stimulus completely without seeing the economy stumble.)

This is exactly what the charts are saying. JC Parets, of All Star Charts, recently called the daily chart of the long bond, “one of my favorite charts in the world,” as it looks like it is now breaking out to new highs, a very bullish development:


Conversely a long-term look at the yield on the 10-year treasury bond shows it is still well within a very clear downtrend:


I wouldn’t consider this a “rising rate environment” until this downtrend is convincingly broken. In fact, the only rates that seem to be rising lately are on the short end of the yield curve which has flattened considerably since the Fed began its tapering its QE program:


Note that, “the slope of the yield curve is one of the most powerful predictors of economic growth, inflation and recessions.” The curve is still positive but the fact that it’s flattening suggests we should be more worried about a reduction in “economic growth” and “inflation” than the opposite.

The bottom line is I just don’t see any evidence to suggest that we are in anything resembling a “rising rate environment” or that one is even anywhere on the horizon. This is not to say that somewhere down the road there may be consequences for the Fed’s easy policies and one of those may be rising rates. It’s just not happening right now.

Economy, Investing, Markets

Can’t You Hear Me Knockin’?

That’s what the bond market is asking the Fed right now as it tests this downtrend line:

sc-2The Fed hasn’t even begun to taper and the 10-year treasury rate has nearly doubled over the past 18 months. What the equity market may be starting to worry about over the past few days is if $85 billion per month in bond buying can’t keep rates down then the Fed may have a real problem on its hands.

Over the past few years “quantitative easing” has done a great job of suppressing bond rates and thus stimulating the economy with cheap money. However, the bond market is now showing signs of revolt. Should the Fed lose control of long rates the economy could suffer the effects of money getting more expensive, the inverse of QE’s effect over the past few years.

Convincingly breaking above this downtrend would be both a major blow to the Fed’s confidence game and a signal that it is, in fact, losing control of the long end of the bond market.

Charts, Economy, Investing, Markets

The Four Pillars Holding Up The Stock Market Are Crumbling

Earlier this week I wrote, “why I’m bearish,” focusing more on why I am willing and able to take a contrarian stance than on the real reasons for taking it in the first place. So here I’m going to make the case for being bearish right now.

pillarsThe stock market is held up by four pillars: fundamentals, technicals, sentiment and macro (see Todd Harrison’s “The Four Pillars of Trading“). All of these must work in concert, to some degree, for stocks to go either higher or lower. Right now I believe they are conspiring to send prices lower.


The most fundamental part of investing is knowing that ‘the price you pay for a stock determines your rate of return.’ If a stock is worth $100 and you pay $50 you will make 100% when/if the market recognizes its true value. However, if you pay $150 for the same stock you stand to lose 33% so price, and more importantly valuation, is absolutely critical in the investment process.

valuationsRight now stocks are very expensive. Based on four different valuation metrics, courtesy of Doug Short, stocks are currently overvalued somewhere in the range of 42%-70%. In other words, if stocks were to immediately return to their average historical valuations tomorrow they would have to fall 30%-40%. This is why James Montier and Jeremy Grantham have calculated that the probable return for the stock market over the next seven years is roughly 0% (earnings should grow but valuations should decline leading to zero return).

It’s important to note, as well , that there are only two other times in the past 100 years when stocks were prices as high: the 1929 bubble and the 2000 bubble.

profit marginsFundamentally then, the only way this “pillar” becomes bullish for stock is if corporate earnings grow very rapidly over the next few quarters. The problem with this idea is that corporate profit margins are already historically stretched AND earnings growth has slowed nearly to a stop as companies revise their forward guidance downward faster than ever.


spxStocks are up nicely this year but there are signs that momentum has begun to wane. As the S&P 500 has made new highs RSI and MACD have failed to confirm them. In addition, the index has now formed a clear “ending diagonal” or “wedge” reversal pattern.

Turning to the Nasdaq, it has also formed a similar pattern. What’s more, on Tuesday it completed a 9-13-9 DeMark Sequential sell signal on the monthly chart. At the same time it has now retraced 61.8% of its decline since the internet bubble burst. This is a key Fibonacci level that traders follow because it regularly marks changes in trend. Notice that the 2007 top was formed very near the 38.2% level (the inverse of 61.8%). The triple threat of the ending diagonal, DeMark sell signal and key resistance significantly increases the probability of an imminent reversal on this long-term time frame.



We can look at all the surveys there are to gauge sentiment but I prefer to look at what investors and traders are actually doing with their money. There are two in particular we should pay close attention to.

The first is short selling; there’s no better way to determine how many bears there are out there than to take a look at short selling levels. According to this measure, bears just hit an all-time record low. Markit recently revealed to CNBC that a mere 2.4% of S&P 500 companies’ shares have been borrowed to sell short, a record low. Clearly, rising stock prices have forced bears into hibernation.

margin debtOn the flip side, the bulls are out in force. Margin debt levels have recently risen higher than any other time since the internet bubble. Not only are most investors heavily long stocks, they are leveraging their exposure with a massive amount of margin debt.

The bottom line is we currently have a record low in the number of bears while bulls numbers near record highs. Contrarians rarely see sentiment so extremely skewed.


SPYFedTopsBottoms-1024x695Here’s an area I’ve been writing about for months. This stock market is essentially ‘all Fed, all the time.’ And if you doubt the impact the Fed has had on the bull run stocks have made over the past few years, take a look at the chart to the right, courtesy of TheArmoTrader.

The Fed has made it clear it sees the need to “taper” its bond buying programs. And in the words of one of the most successful investors of all time:

If you didn’t believe before that the exit was gonna be tough, the mere hint that maybe in 3 months, if the economy’s good, we might go from 85 billion a month to buying 65 billion a month caused that kind of havoc and risk around the world how in the world does anybody think that when the actual exit actually happens prices are not gonna respond? It’s silly. -Stan Druckenmiller

Make no mistake, the stock market has benefited greatly from the Fed’s money printing; the end is near and stocks will suffer when it comes. The only question that remains is ‘will investors try to get ahead of the actual announcement?’ because it seems the “smart money” is already doing so.

scInvestors in the bond market have certainly gotten ahead of any tapering that may be on the horizon. Interest rates have shot up over the past few months, a development that is neither good for the economy nor for other asset classes. Take a look stocks reacted at prior times interest rates surged to this degree. Two out of the past three occurrences coincided with major stock market tops.


All in all, each of the four pillars presents a challenge for stocks at present. In fact, we haven’t seen this combination of extreme valuations, waning momentum, rampant bullishness and macro threats since just before the financial crisis. Now I’m not calling for another stock market crash but the risk-reward equation seems heavily skewed to the risk side with very little possibility of reward. That’s a game I have no desire to play so go ahead and color me “bearish.”

Economy, Investing, Markets

3 Signs The Fed’s Confidence Game Is Up

bernanke titanicI’ve been writing for about year now about the Fed’s “confidence game” and its risk to the financial markets. When I first floated the idea I wasn’t too worried about the risks at the time. However, it seems the end game is quickly nearing and so it may now pay to take some risk off. Here’s why:


Despite nearly a trillion dollars of money printing over the past year the economy continues to merely limp along. In the words of Martin Feldstein:

The FOMC’s projections in recent years have been repeatedly too optimistic. It looks as though they are repeating the mistake again. At the end of its recent FOMC meeting the Fed released a summary of the economic projections of the FOMC members – the governors of the Fed and presidents of the 12 regional Federal Reserve banks. The central tendency of these projections foresees real gross domestic product growth of 2.0-2.3 per cent for the 12 months starting with the fourth quarter of 2012. That would be higher than the US economy has achieved in any of the past three years. For the first half of 2013 the official annualised GDP growth number is now only 1.8 per cent, and more than one-third of that growth was just inventory accumulation. Private estimates for GDP growth in the current third quarter are at about the same level.

The economy is just not as robust as anyone would like and there are few signs that all this money printing is making a major positive impact.

In his latest press conference Ben Bernanke also expressed his disappointment on the employment front. The headline unemployment rate is 7.3% but it is instructive to look at the percent of the population participating in the workforce. That number has dropped from 51% to 49% over the past six years and the trend is a big headwind to the economy. It may be that people simply give up looking for work. It may also be that the demographic trends in our country are such that we simply have more people retiring than entering the workforce. Either way, QE clearly hasn’t done anything to improve the situation.


Take a look at this new trend in media headlines covering the Fed:

Screen Shot 2013-09-27 at 1.47.41 PMScreen Shot 2013-09-27 at 1.48.27 PMScreen Shot 2013-09-27 at 1.47.19 PMScreen Shot 2013-09-27 at 2.35.53 PMScreen Shot 2013-09-27 at 2.36.54 PMScreen Shot 2013-09-27 at 2.37.28 PMScreen Shot 2013-09-27 at 2.38.15 PM

After its decision not to taper QE sentiment toward the FED is clearly turning against it. Even the majority of Americans now believe that QE is a sham:


Notice the actual language in the poll question: “How much confidence do you have in the Federal Reserve….” 38% of respondents answered “none” or “not much” outweighing the 32% said “a lot” or “some.”

This is likely due to the fact that QE’s been most effective in boosting the prices of risk assets which mainly benefits the rich. The majority of the population has seen literally no benefit. Which has led some pundits to suggest that once the general public realizes the cost of all this money printing and that it has only benefitted the wealthiest of the wealthy there may be a serious backlash. (See “Occupy QE” and “Fed accused of covering up soaring inequality“)


The stock market rallied hard immediately after the no-taper decision but has now given back all of those gains. But the big story is in the bond market. When the Fed started QE1 back in the fall of 2008 rates plunged. They fell once again upon the implementation of QE2 in late 2010. QE3, however, has been met with heavy bond selling and rates have soared even while the Fed has been buying hand over fist:


This should serve as a major warning to investors that the markets are no longer under the Fed’s spell. They may buy a trillion dollars worth of bonds but it’s having literally no impact on long-term interest rates. Make no mistake, the markets are revolting even if the people haven’t yet.


Ultimately, I think the the Fed’s quantitative easing measures were necessary and hugely successful during the financial crisis in restoring investors’ faith. After four years of this stimulus, however, it’s slowly lost its power. It’s like a coffee drinker who started with a cup a day and has worked his way up to a couple pots of coffee a day. That first cup in the morning doesn’t do much more than keep him from falling back asleep.

Markets, investors and the economy have built up such a tolerance to QE that $85 billion per month simply doesn’t have any noticeable affect at all – not even on confidence anymore. But the Fed recognizes that without it we’re going to have one hell of a headache. So for now they will continue printing money without tapering because that’s become the de facto neutral.

Still, QE must come to an end at some point. The Fed simply can’t expand its balance sheet by over $1 trillion per year for eternity. This is what precipitated the whole “taper” discussion in the first place. That doesn’t change the fact that it’s going to be a very painful process when it does end. And now it looks like the reality of its impotence, the backlash from the media and the public and, most importantly, the markets are going to force their hand.

Other articles from the past week: