At which point do rising interest rates spark the fire? Rates are key to the equation of risk. In Friday’s On My Radar, Steve surveys what the current equity market valuations tell us about risk… and likely forward returns. Should you be playing more offense than defense or more defense than offense? Valuations can help.READ MORE
You may have heard the phrase, “three steps and a stumble.” It means that when the Fed raises rates three times in a row, a market stumble is likely to follow.
Following is a visual look at that rule:
- The S’s in the chart mark the third consecutive rate hike
- Note how the hikes almost always precede a new recession
- Note the current signal is a sell or “S” and
- Note the DJIA has declined a median of 17.9% from sell signals to bear market bottoms
The Fed raised rates last week and bond yields sank lower. Many expected the opposite reaction. If you missed last summer’s mortgage refi opportunity, I believe you are going to get another chance. Interest rates appear to be heading back down towards their July 2016 lows.
And what are the implications of Fed policy on the U.S. stock market? Ned Davis Research’s Ed Clissold pointed out in a tweet late yesterday, “Today’s #FOMC decision is a reminder that even slow tightening cycles eventually impact the stock market. #fed @NDR_Research.”
The chart Ed shared in his tweet follows. Here is how to read it:
- NDR compares market gains during slow tightening cycles (black line in chart) vs. fast tightening cycles (red line in chart) vs. non tightening cycles (green line in chart), and more.
- It looks at what happened historically to the stock market in periods when the Fed was quickly raising rates vs. slowly raising rates – like the current cycle.
- The purple line is the current Fed tightening cycle that began in December 2015.
- Note how NDR breaks out % Gain During 1st Year and % Gain During 2nd Year. We now find ourselves in year 2. Purple line (right-hand side of chart).
- Year 1 gains averaged 10.8%
- Year 2 gains averaged -1.8%
- The green line shows non-cycles… markets do better when the Fed is lowering (easing), not raising (tightening), interest rates. “Don’t fight the Fed” as they say.
In Friday’s On My Radar, Steve Blumenthal wrote, “Last Monday, the VIX broke below 10 to close at 9.77, the lowest level in more than a decade. There are only three other days the index has closed at lower levels, all of them in December 1993. Investors are complacent to risk. They shouldn’t be.”
Investment consulting firm 720Global also recently wrote about market volatility in The Unseen, “Volatility: A Misleading Measure of Risk.”
As investors, we are negligent if we follow the Fed’s lead into this complacent stupor. By prodding economic growth with unproductive debt and reigniting asset bubbles, the central banks have simply done more of what created the spasms of 2008 in the first place. Despite the markets calm façade and historically low perception of risk, the vast chasm that lies between perceived risk and reality is troublesome.READ MORE
Following a two-day meeting of the policy-making Federal Open Market Committee (FOMC), the Federal Reserve held current interest rates steady, but the central bank is likely to raise rates in the coming months (possibly in mid-June). Fed officials are not worried about the slow pace of growth during the first quarter of 2017. (U.S. GDP grew at an annualized rate of 0.7 percent.) The Fed said the slowdown was “likely to be transitory.”
“Inflation measured on a 12-month basis recently has been running close to the committee’s 2 percent longer-run objective,” the Fed said. Household spending rose “only modestly” but the fundamentals underpinning consumption growth “remained solid.”
Declines in the unemployment rate has been the primary driver behind the Fed’s recent rate increases. The unemployment rate fell to 4.5 percent in March, the lowest level since 2007. (The Labor Department will release the April jobs report on Friday.)
Ray Dalio established Bridgewater Associates in 1975. With $150 billion under management, Bridgewater is the largest hedge fund in the world. The firm has approximately 350 institutional clients, including public and corporate pension funds, university endowments, charitable foundations, supranational agencies, sovereign wealth funds and central banks.
In 2015, Bridgewater published Economic Principles, a research paper discussing the driving forces behind the economy, and explains why economic cycles occur by breaking down concepts such as credit, interest rates, leveraging and deleveraging. Here at CMG, our interns are required to read Economic Principles, among other books. Though lengthy, it is the best working model on global economic cycles, debt, education, inflation and more I have read.
Dalio was interviewed by CNBC’s Andrew Ross Sorkin at last month’s CNBC Institutional Investors Delivering Alpha Conference. In this week’s On My Radar, we summarize the interview and address Dalio’s question, “Are we at the end of a long-term debt cycle?”READ MORE
Yields are at 5,000-year lows.
71% of the world’s government bonds are yielding less than 1%. 33% yield less than 0%. In a picture it looks like this:
Source: Bloomberg; JPMorgan Asset Management, BofA Merrill Lynch
Risk is being overlooked in HY bonds. Yields on high yield debt are close to the same yields on less risky loans. The chase for yield has driven investors to riskier asset classes.
I am anticipating a once-in-a-generation buying opportunity in HY bonds. While the trend this week is up, continue to invest with the trend. Move to the safety of cash or Treasury Bills when the trend crosses down.
Click below for a great chart showing what a 1% increase in interest rates does to bond prices. Show it to your clients!READ MORE
If you read just one piece this week, read John Mauldin’s “Monetary Mountain Madness.”
John’s promise: “I trust that by the end of this letter you will better understand just how bankrupt – and disastrous – what passes for sound economic thinking among the world’s central bankers actually is.”
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— Stephen Blumenthal (@SBlumenthalCMG) April 13, 2015
Every security is priced off of Fed-set interest rates. The ultimate question is, are rates going higher or lower? The answer to that trickles through every other asset class, affects borrowing rates, corporate liquidity, profit margins and credit risks, stock valuations etc.
Bank rates have come down but, according to Martin Armstrong, the spread that banks are charging vs what they pay in deposits and what they charge in loans is near a record high. Individuals and corporations have been largely deleveraging. Less spending = slow economy. The same thing happens when you take more money in the form of higher taxes. Expected higher tax and higher regulation changes ones view on future expected return and shapes decisions on business expansion and risk taking.
The current Keynesian central planning approach is not the answer. The answer is in letting millions of individuals seek solutions, create new things, seeing opportunities, taking chances, filling needs, driven by their own self interest and the interest of their individual teams that when aggregated up creates a larger and healthier collective whole.
Armstrong says he has the largest economic database in the world. He believes that it has helped him better identify major trends and turning points. That has come in handy in combination with his Adam Smith approach of staying unbiased and letting the data speak instead of the Marx-Keynesian approach of trying to force the free markets to do as a few central planners think best.