Messages from the Bond Markets
The fact that so many people expect interest rates to be on the rise is a contrarian’s delight. When it comes to investments, the biggest crowd is almost always wrong. The brave souls willing to buy their straw hats in winter normally get the best bargains.
Listen to news reports, read articles by financial pundits and talk to people you know and most everyone will tell you that rates are rising. Don’t believe it! Interest rates began a stealth decline over the past few weeks, one that looks to have legs.
I look at 19 different interest rate indicators that each measure different things over different periods of time. Virtually all of these indicators have flipped over to green during the past few weeks (written July 23rd) and we have begun buying bonds for our managed accounts. We are still within the narrow range that interest rates have been in for the past 3 months. These narrow ranges make many of my indicators hover close to the actual rates, so smaller interest moves can trigger an indicator change. But I now have enough consensus among my indicators that I have to call them as I seem them.
Rates are trending down which means bond prices are trending up.
Of course as a contrarian, now we might expect a blip up again in rates (Murphy’s law, and all), but other work we have done indicates the greater trend toward lower rates will continue.
The good news is that interest rates have a good chance of declining for quite a while, perhaps until the end of the year at least. With interest rates affecting our lives in so many ways this is good news in a lot of ways.
The bad news is that the reason I think we will see rates on the soft side is that the markets are telling us that a business slowdown, perhaps even an economic recession is on the horizon. With the economy affecting us in so many ways, this is bad news in a lot of ways.
Currently, the stock market is weak, and looks like it may get weaker before it gets stronger. The CRB Commodities Index is showing signs of topping out. That the prices of commodities, oil, cement, steel, etc., have been driven to record levels by hot economic activity is no secret. But what goes up comes down, and commodity prices, in aggregate, are no longer rising and appear to be poised to come down in a meaningful way.
Get ready for lower gasoline prices. You heard it here first!
With interest rates appearing to have topped out for this cycle, we have a classic trifecta of factors that points to a change in the business cycle from expansion of the economy to contraction. If the economy contracts for two quarters we will have met the definition of recession.
Perhaps it is too early to be using the R-word, but more economic expansions have ended due to rising interest rates and rising oil prices than any other cause, and we have endured both for a couple of years now. Engineering a soft landing for the economy may prove to be a difficult task for the Fed given how many times they overshoot when trying to tap the brakes to control inflation.
Plus, I believe that readers need to know if a recession is possibly headed their way before the official pronouncements are made. By the time the government collects all the data, takes time to crunch the numbers and waits for the second full calendar quarter’s results to show outright shrinkage in economic activity and then announce that we have a recession underway, the worst will already be over. Those who wait for official word to defend themselves financially will simply be too late.
The financial markets are always looking 6-12 months ahead and savvy investments are based upon that outlook, not today’s. Don’t be confused by the pronouncements you hear on TV or in the papers of why the market went up or down today. Those are just rationalizations chosen to sell papers or mollify viewers. Today’s news has little impact on the real trend of the markets. The bond market action is telling us that in 6-12 months business will be bad. That’s the news that counts.
To add to the weight of evidence pointing toward a business slowdown is what we call the “yield curve”. This is the relationship of shorter term rates and longer term rates. Longer term rates are almost always higher than shorter term rates to pay for the added purchasing power risk (inflation) of longer term bonds. When graphed out, short and long term interest rates will almost always generate an upward sloping curve – the yield curve.
Almost always. The exception, when long term rates are lower than short term rates doesn’t occur very often, but when it does it is one of the most reliable indicators we have of a future business slowdown or recession.
Right now, 2-Year Treasuries are sporting interest rates slightly higher than both 5-year and 10-year bond rates. “Fed Funds Rates”, overnight rates among banks are higher than all Treasury rates, 2-years, 10-years and 30 year bonds. This is backwards and has created an “inversion” in interest rates. The inversion is not huge, but rates are inverted nonetheless. This is a big indicator of what we might expect from the economy. It is saying look for the economy to slowdown and possibly enter a recessionary period.
As businesses begin to slow down, fewer will borrow money to expand. As the demand for borrowed money drops off, and the price of borrowed money, interest rates, will begin to decline until rates find a level at which the money will get used, where supply equals demand. This is the function of the various facets of the bond market, to determine how much borrowers are willing to pay for 3-month T-bills, 10 year T-notes or 30 year fixed rate mortgages.
So over the next few months, I won’t be surprised to see rates decline as borrowing demand falls off. Shorter term interest rates and ARM loan rates may fall more than 30 year rates, but look for lower rates in general.