A Turn in the Tide: The Case for Rising Interest Rates
The purpose of this article is to make the case for a primary trend rise in yields. If this assumption turns out to be correct, it is within the realm of possibilities that this same rally may also be a turn in the tide for the initial advance in a new, very long-term or secular uptrend. Our quest as investment advisors is to detect significant changes in financial asset trends as early as possible. Early detection of cyclical and secular turning points and aligning portfolios with those new trends makes our mission to protect and grow clients’ valuable assets easier and with less risk. If the primary trend in interest rates has reversed its multi-year decline then bond holders will be subject to massive portfolio losses.
Secular turning points usually develop as markets overshoot and crowd psychology moves to an irrational extreme. At such times, accepted standards no longer apply as markets temporarily move to nonsensical extremes. For example, at the 1990 peak of the Japanese real estate boom, the Emperors’ palace was said to be worth more than the real estate value in California. At the height of the tech boom in 2000, the travel website Priceline.com had a capitalization greater than the combined value of all the major US airlines. It is not inconceivable that global bond markets have reached a similar type of illogical turning point. For example, a recent Wall St Journal article featured a Danish home owner who took out a mortgage. He did not pay any interest, but instead was obligated to receive payments in return for taking out the loan. Five thousand years of interest rate history says it should be the other way around. Welcome to the world of negative interest rates! It is possible that such irrationality can continue, but it is more likely that it will not. Just bear in mind the actuarial challenges for life insurance companies, pension funds and other entities as they struggle to provide for future obligations with returns on fixed income vehicles well below that of their fiduciary requirements.
During the last few decades holding bonds has paid off as substantial capital gains have compensated for declining current return. Now that rates are close to zero, capital gains cannot continue. The only way they could, is for the markets to push yields deep into negative interest rate territory. That would mean pension funds, for instance, would be paying to invest instead of receiving income as a return on capital.
While we think there is a very good possibility rates are in the process of reversing their secular downtrend, more evidence in that direction is needed before coming to a firm conclusion. What can be said, though, is that economic and technical forces justifying a primary trend reversal are rapidly falling into place. Whether that cyclical advance would be sufficient to reverse the post 1981, 35-year downtrend, is a question that will have to be addressed later.
The growth path of the economy represents a broad proxy for the demand for credit and can therefore be useful in identifying basic reversals in the trend of interest rates. Some indicators that measure tightness in the system, such as capacity utilization, work well some of the time but have been inconsistent at calling interest rate rallies during the secular bear.
We never expect anything to be perfect, but a composite indicator calculated from a rate-of-change of several economic components has been better than most. We call it the “Growth Indicator” and it is plotted in Chart 1 below.
Chart 1 The Commercial Paper Yield versus the Economy (Source: Martin Pring’s InterMarket Review)
A rising economy generally pushes shot-rates higher.
Green highlights indicate when it is above zero; i.e., reflecting an expanding economy, and red when below. Federal Reserve policy has been particularly accommodative in the last few years, which could explain why our model gave a false signal of strength in the 2009-2011 period. Whenever a fundamental indicator is used, it makes sense to combine it with a trend following technique. In that way we can see whether the price series being monitored is responding to any fundamental changes. Our weapon of choice in this regard is the 12-month MA. On that basis the recent positive zero crossover by the Growth Indicator has certainly been confirmed by the yield action, whereas, say the false positives in the 2002-03 and 2009-2011 were not. So this economic ‘Growth Indicator” is showing investors should expect rising interest rates and therefore lower bond prices to go along with a rising economy.