Update on Bonds: Aug 22, 2016

In our last major update on bonds [May 24, 2016 Update on Bonds] I detailed the brokenness of the bond market’s relationship with stocks.  At the time, TNX was looking rather vulnerable.

[TNX] has since put in two lower highs — hardly the sort of behavior one would expect if higher rates are, indeed, right around the corner.  On the other hand, it’s hard to miss the triangle pattern setting up over the past several months.

2016-05-24 TNX v SPX 60 2100

May 24, 2016

IMO, it’s not so far off the lows that it qualifies as a legitimate pennant pattern.  But, it obviously represents a coiling of sorts — exactly the sort of pattern one would expect with a rate decision coming up next month.

The Fed punted in June, and again in July.  There was always something a little too scary lurking in the bushes: disappointing employment figures, Brexit, the latest Kardashian drama.

In the July minutes released last week, we saw that the Fed wants both “great taste” and “less filling.”  They want investors to believe them when they say a rate increase is really, really, really on the way.  They just don’t want to ever have to deliver on that threat.  And, it makes sense, in the kind of logic that only a central banker could appreciate.

As a nation that imports almost everything, the US needs the dollar to remain high.  The best way to do that (without having to resort to currency manipulation) is to maintain interest rates that are higher than those of other developed countries — not hard to do, when many of them are below 0%.

Should investors begin to doubt your resolve to maintain those spreads…well, that’s what CNBC is for, right?  So far, talking about higher rates has been just as effective as having higher rates.

Good thing, too, because we can’t afford actual higher rates.  With $19.4 trillion and counting in direct Federal debt, we can’t even afford the ridiculously low rates we have. Take 2015 for example.  We ran a $500 billion deficit with 2% interest rates.

Which other $450 billion in spending could we eliminate if rates tripled to a historically normal 6%?  Hey, maybe we could just raise taxes.  It’s only an extra $1,200 annually for every man, woman and child.  Ain’t gonna happen.

Screen Shot 2016-08-22 at 7.37.51 AM

It seemed rather far-fetched when, in May 2014, Bernanke was quoted as saying fed funds wouldn’t normalize in his lifetime.  Now, it seems positively near-fetched.  The Fed has spent years threatening — but never delivering — higher interest rates (unless you count last December’s 0.25% increase, which scared the crap out of the FOMC.)

The inflated dollar helps (along with a definition that changes as/when necessary) keep reported inflation at bay — which is critical when you’re trying to convince folks that accommodative policy is essential in order to increase inflation (supposedly a good thing.)

Otherwise, investors might get the silly idea you’re doing it just to prop up stocks.  I mean, how ridiculous is that!?

Okay, so what does all this have to do with ten-year interest rates?  I’ve been trotting out the chart below for years, noting how the traditional relationship between interest rates and equity prices broke down in 2014.

2016-08-21 TNX v SPX wkly 1228

In our May update, however, I pointed out that the traditional relationship had finally been restored.  That is, a plunge in interest rates had accompanied a plunge in stock prices — just like the good old days.

Hope you enjoyed it while it lasted.  Because, when the pennant pattern broke down in early June, stocks didn’t — at least, not for long. The plunge from 2% on Mar 16 to 1.34% on Jul 7 matched up with a 3.6% increase in SPX.  2016-08-21 TNX daily 2200

But, even that statistic obscures an intriguing movement in rates that has important implications for bonds going forward.

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