2013-10-02

The Heart of the Matter: Interest Rates

This is the trillion dollar question: did rates increase because of the taper (the start of the 10-year Treasury interest rate spike was timed around Bernanke's taper comments in May) or is it a more fundamental shift (possibly driven by a global shift pulling U.S. rates higher, a stronger economy, or simply investor psychology)?

I argue the Fed is in a box, potentially, if rates move higher because then what do they do? Their only option is to increase QE, there is no alternative then, but if rates keep rising? It is game over.

Here's Fleckenstein on the matter: Final countdown on markets' third bubble
If the bond market (with maturities of five years and out) is no longer willing to follow what is dictated by short-term rates and the central banks, then higher yields lie ahead. Since no one really expects that, higher rates will wreak havoc throughout the financial system and various economic structures.

At some point, the realization that the Fed no longer controls interest rates will cause a "reset" in the stock market, which will be at a level quite a bit lower than where it is today. I expect the Fed to fight this eventuality with even more money, but of course that won't work, though it will be beneficial for precious metals.

In short, in the next month or so, we will find out just what the bond market wants to do. But I expect the current rally to fail and that the key to when trouble starts will be when yields on 10-year government bonds climb back over 3.00%.
This is the heart of the matter. What happens with interest rates moving forward: is this a correction, a new trading range with a top around 3%, or was the spike really all taper related? Trouble starts at 3% because that's when the technical analysis guys will all start looking for higher rates and firms with a lot of capital at stake will start hedging. In other words, the herd will start slowly moving. I think 4% might be the level above which things really risk going haywire because at that point, all of QE has failed; 10-year Treasuries are back to 2008-2010 levels.

Here is a post from Acting Man on how the bond prices relate to market signals. Stock Market, Long Term Structure Update
B.A., our friend and occasional contributor of Elliott Wave counts, has sent us an update of his long term wave count of the NYA Index. The NYA is of special interest to us mainly because it is a very broad index containing thousands of securities. What is especially noteworthy about this chart is however not only the wave structure, but also the breadth/price divergence that has begun to become apparent during the most recent leg of the rally.

We believe the main reason for this growing divergence between prices and breadth is the fact that long term interest rates have increased, which has put pressure on the market's interest-sensitive sectors. However, from a purely technical perspective the 'why' isn't really all that important. What is important is that such a divergence constitutes a long term warning sign: the market is still rising, but fewer and fewer stocks are participating in the rally.
The NYA Index has a lot of bond funds that sink when rates go up.

The end isn't night, but the clock is ticking down. The higher rates go, the closer the top in the stock market.

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