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Why Stock Market Bulls Should Hope Interest Rates Don't Rise
Submitted by Lance Roberts via STA Wealth Management,
Yesterday, I participated in a panel discussion on CNBC about the markets and the economy. It was during the course of that discussion that one of the participants uttered the most important phrase:
"Everbody knows interest rates are going to rise."
First, let me explain my reasoning for why it is possible that "everybody" is wrong. As I addressed last week in "Interest Rate Predictions Meet Rule #9" when everyone is expecting something to happen, it is often the opposite that occurs.
"As you can see there is a very high correlation, not surprisingly, between these three components (inflation, economic and wage growth) and the level of interest rates. Interest rates are not just a function of the investment market, but rather the level of "demand" for capital in the economy. When the economy is expanding organically the demand for capital rises as businesses expand production to meet rising demand. Increased production leads to higher wages which in turn fosters more aggregate demand. As consumption increases, so does the ability for producers to charge higher prices (inflation) and for lenders to increase borrowing costs.
However, in the current economic environment this is not the case. The need for capital remains low, outside of what is needed to absorb incremental demand increases caused by population growth, as demand remains weak. While employment has increased since the recessionary lows much of that increase has been the absorption of increased population levels. Many of those jobs remain centered in lower wage paying and temporary jobs which does not foster higher levels of consumption."
Whether you agree with this premise, or not, is largely irrelevant to this discussion. The current "bullish" mantra is the "great bond bull market is dead, long live the stock market bull." However, is that really the case?
When the bond bubble ends this means that bonds will begin to decline, potentially rapidly, in price driving interest rates higher. This is the worst thing that could possible happen.
1) The Federal Reserve has been buying bonds for the last 4 years in an attempt to push interest lowers to support the economy. The recovery in economic growth is still dependent on massive levels of domestic and global interventions. Sharply rising rates will immediately curtail that growth as rising borrowing costs slows consumption.
2) The Federal Reserve currently runs the world’s largest hedge fund with over $4 Trillion in assets. Long Term Capital Mgmt. which managed only $100 billion at the time, nearly brought the economy to its knees when rising interest rates caused it to collapse. The Fed is 40x the size and growing.
3) Rising interest rates will immediately kill the housing market taking that small contribution to the economy away. People buy payments, not houses, and rising rates mean higher payments. (Read "Economists Stunned By Housing Fade" for more discussion)
4) An increase in interest rates means higher borrowing costs which leads to lower profit margins for corporations. This will negatively impact corporate earnings and the financial markets.
5) One of the main arguments of stock bulls over the last 5 years has been the stocks are cheap based on low interest rates. When rates rise the market becomes overvalued very quickly.
6) The massive derivatives market will be negatively impacted leading to another potential credit crisis as interest rate spread derivatives go bust.
7) As rates increase so does the variable rate interest payments on credit cards. With the consumer being impacted by stagnant wages and increased taxes, higher credit payments will lead to a rapid contraction in income and rising defaults.
8) Rising defaults on debt service will negatively impact banks which are still not adequately capitalized and still burdened by large levels of bad debts.
9) Many corporate share buyback plans and dividend issuances have been done through the use of cheap debt, which has led to increases corporate balance sheet leverage. This will end.
10) Corporate capital expenditures are dependent on borrowing costs. Higher borrowing costs leads to lower capex.
11) Commodities, which are very sensitive to the direction and strength of the global economy, will plunge in price as recession sets in.
12) The deficit/GDP ratio will begin to soar as borrowing costs rise sharply. The many forecasts for lower future deficits will crumble as new forecasts begin to propel higher.
I could go on, but you get the idea.
However, for those of you who still doubt that rising rates are bad for stock market returns, let me put into graphical form for you.
The chart and table below show what happens to the financial markets, and the economy, when interest rates increase.
The problem with most of the forecasts for the end of the bond bubble is the assumption that we are only talking about the isolated case of a shifting of asset classes between stocks and bonds. However, the issue of rising borrowing costs spreads through the entire financial ecosystem like a virus. The rise and fall of stock prices has very little to do with the average American and their participation in the domestic economy. Interest rates, however, are an entirely different matter.
What would be required to diminish the impact of bursting bond market bubble is a slow, and controlled, unwinding of the bond market over an extremely long period of time. The Fed would have to step up interventions on a massive scale to offset the selling of the bond market to curtail the rise in rates. Even with that, I would expect a rather sharp economic deceleration as the housing market grinds to halt and overall consumption declines. The actual achievement of such a counter balance to a market as large as the bond market is difficult to fathom.
However, while bond prices are near historic highs, with interest rates near lows, it would certainly seem as if bonds are in a bubble. However, if interest rates are a reflection of economic growth, inflation and wages, as the first chart above suggests, then rates are likely "fairly valued."
As I discussed yesterday, there is an ongoing belief that the current financial market trends will continue to head only higher. This is a dangerous concept that is only seen near the peak of cyclical bull market cycles.
"We saw much of the same analysis as Brad's at the peak of the markets in 1999 and 2007. New valuation metrics, IPO's of negligible companies, valuation dismissals as "this time was different," and a building exuberance were all common themes. Unfortunately, the outcomes were always the same. It is likely that this time is "not different" and while it may seem for a while that Brad analysis is correct, it is 'only like this, until it is like that.'"
The point here is that while the current trends can last longer than reasonably believed, which is why we currently remain invested in the markets, it is inevitable that things will change. The problem for most is that by they time they recognize that the underlying dynamics have changed it will be too late to be proactive, only reactive. This is where the real damage occurs as emotional behaviors dominate logical processes.
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Savers are terrorists. Interest rates should be negative.
I was wondering what happened to you Ben.
Everyone involved in paper wealth in any way, shape, or form should be worried about rising interest rates.
Rising interest rates equals game-over. This is why rates will stay low for a lot longer than everyone is predicting.
Silly people keep identifying a political economy as a market economy for some strange reason.
ZIRP will rule as long as the dollar does.
GOT PHYS???
But can they really be held low?
What if the last two stock implosions were to keep interest rates low? Interest rates have to stay down to keep the central masters in power and they make money if stocks go up or down. What if they are getting ready to do it again?
All them insolvent arsehats will be ... well ... insolvent.
Liquidity?
Screw'em
Spend your fucking money or hang by your neck at City Hall, your choice!
Rising interest rates would result in a real Great Depression....
...and the death of fiat is going to be better?
good luck with that.
All paths are fraught with peril...
oh please let me have just a little bit of peril, there's only 350 of them...
What about falling rates? No Sarc.
Rates fell after QE1 & 2 ended.
They've gotta flatten out that yield curve some more in order to 'buy' themselves a little more time, I reckon.
Or will they introduce 50 year bonds first????
It would indeed ... for some. All those shats who have borrowed money thinking that inflation was going to save them ... well ... negative net worth is negative net worth.
Or rising rates would attract funds that are now sitting idle. Rates will only rise so far as those dollars satisfy the demand for them.
Those dollars are the market's way of setting the price based on supply and demand.
What good are low rates if there is no demand? As we can see, there is No good.
For God's sake, can't we get back to letting the market place iron this out for us? It really did work well, before all the meddlers got involved.
What garbarge is this? With the oligarchs in most contries doing whatever the fuck the want, the answer to how long this can continue (no rule of law/contracts etc.) is very clear.
It can and will continue until the bread, circuses, and oil can no longer actually be delivered.
Then and only then will things get very fucking real.
Nuclear powered subs with nuclear tipped MIRv warheads guaranfuckingtees it will continue until theres nothing left.
Did you mean Nuclear Powered FED with Nuclear tipped ZIRPs warheads?
Interest rates won't go up until after the great reset - until then, nothing of significance.
And after that reset, nobody is going to be caring about interest rates...
Does CNBS really have to push me a push an alert every fucking time somebody signs up for Zerocare? Here is an idea... send me an alert when somebody pays their bill.
BTW... Rates are never going up above 3.5% on the ten year.
Edit: It's been my prediction and I'll reiterate it now, we will see a one handle on the ten year before this is over with.
Every Senate Democrat up for election is going to live or die on Obamacare, even though most want to talk about something else. Their strategists have concluded they can't change the subject so their only hope is to persuade the populace that it is a rousing success.
That will be the narrative for the next 6 mos.
if this is the case it sets all the dems up for that "it's the economy stupid" response by voters...
How about a two handle on the thiry?
BTW, I consider those CNBS alerts to be the best infotainment money can't buy. I can't count the number of times I've gotten one about the same time as I see a ZH post on the same subject... with the exact OPPOSITE interpretation.
As always, do it for teh LULZ.
OK. I'm interested. At 1% on the 10yr, what do the NAS, DOW, S&P, and GOLD trade at? You are implying MASSIVE deflation, you know?
forgot to mention the Zillions in debt....
The fed basically owns the long end of the curve. So yields can't explode higher. Everyone figured out last yr that at 3% on the 10yr the EM's started blowing up so that is the redline. so now everyone is piling into bonds. The fed's actually trying to force the long end up (big NFP) to stop everyone from piling in because they know there is a cap...and oh yeah negative gdp....
They need to just set the 10yr at 2.75% and the 30yr at 4% and execute anyone who tries to move it off those targets.
"They need to just set the 10yr at 2.75% and the 30yr at 4% and execute anyone who tries to move it off those targets." -
Okay, that's funny shit.
He is a desparate man that is about to lose a sandwich.
Very monty-python "ish"...
All liquidity is fungible. Plenty in the hands of the PDs, and with treasure issuance down (smaller deficit, now matching taper) they have some room to relax for a while.
The real cost of energy over the next year will be what makes things interesting.
a virtual sandwich, whatever that is. i'm still torn on this one and would not put a real sandwich on it. There is a chance yellen is holding a flaming bag of shit.
Ooh....ooh... what's the bet? I might want in on the action?
Does he have another bet out there that I don't know about?
NFP miss is the bet. I am on the miss side.
Sounds plausible fonz.
What are your thoughts bout the Mexicans?
pods
"Leo the fart was a good man...a flatulent man"
(my favorite arnold quote)
the mexicans are a fine people pods. good hardworking people, family people. but would they not be better off being used as speed bumps? that is the question we all need to be asking.
I'd say no.
Way too many member banks pressuring their local Fed governor to avoid killing housing. Personally I can't think a few bps on the mortgage matters, but by now they are desperate and will demand the Fed not allow a single uptick in those mortgage rates.
So it's hard to rationalize a managed level higher by any amount at all.
I thought Belgium owned the long end???
You have just defined a 'COMMUNIST' organization, you know?
"if interest rates are a reflection of economic growth, inflation and wages, as the first chart above suggests, then rates are likely "fairly valued.""
The big friggin other driver of interest rates is the supply/demand equilibrium. As the Treasury has ramped up supply over the past 5 years it was equaled (exceeded?) by the demand from the Fed. When the Fed pulls away their portion of the demand prices will drop. Bonds will drop like a rock because there is no replacement for $100B per MONTH.
Except for Belgium of course...
Well interest rates are falling like a rock from the sky and the markets are milling about at all time highs. The sum is super bullish; new highs are a given, dramatically higher highs at that. There is no question that this market is going higher, none.
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Just fix BY LAW an interest rate at 2% on the 30y bonds.
So easy.
FEMA camp for the dissenters.
Not inconceivable.
they don't need a law they have the fed
Mandates, bitchez!
You know how many billions, if not trillions of $$ that would basically be handing the pension funds, for doing nothing of value?
Storm the camps. Fire on anyone in a black uniform or blue helmet. Watch the weenies fold up like inexpensive lawn chairs.
everybody knows interest rates will rise. yEAH, right! LAUGH MY ASS OFF!!
Closely related to all this:
BP takes $520 mil writedown after ditching plan to develop US Utica shale
London (Platts)–29Apr2014/657 am EDT/1057 GMT
BP said Tuesday it is dropping plans to develop its Utica shale acreage in northeastern Ohio as it moves to overhaul its poorly performing onshore shale assets in the US.
BP said it has taken a $521 million write-off relating to the Utica shale for the first quarter of 2014 after lackluster appraisal results from initial well tests.
“As a consequence of appraisal results. BP has decided not to proceed with development plans in the Utica shale,” the company said in an earnings release.
The move comes almost two months after BP announced plan to shift its shale-rich onshore oil and gas assets in the US to a new business to better compete with smaller, more efficient companies such as those which spearheaded the US shale gas boom.
BP said it needed a more nimble business model to reap greater value from the assets, with faster decision-making, quicker field developments and more efficient cost management.
Shell last year announced a strategic review of its US shale portfolio after taking a $2.1 billion impairment on its position due to dire US gas prices.
In Shell’s case, it is targeting its loss-making Americas and oil-product divisions which are tying up a combined $80 billion, or 35% of its total capital employed.
BP signed an agreement to lease about 84,000 acres in the Utica/Point Pleasant Shale formation in northeastern Ohio in March 2012. The play is at a depth of about 6,000 feet and is of a similar thickness to the Marcellus Shale, with the potential to deliver “higher liquids rates,” BP said at the time.
The Ohio Department of Natural Resources estimated a recoverable Utica shale potential of 1.3 billion-5.5 billion barrels of oil and 3.8 Tcf-15.7 Tcf of natural gas, BP has said.
BP holds a significant portfolio of unconventional resources in the US which are estimated to hold a total of 7.6 billion barrels of oil equivalent.
The assets, which include stakes in the Fayettevile and Eagle Ford shale plays, cover a total 5.5 million acres and an interest in over 21,000 wells.
BP currently produces around 300,000 boe/d in the continental US states, also know as the onshore Lower 48, much of which is gas from shale or other unconventional sources.
Please God, please...8% on the 30 year Treasury...
Bye-bye insurance companies, banks, and most pensions if that happened. As they're chock-full of that long-term crap currently marked at dramatically lower interest rates.
Boo-fuckin'-hoo for the Banks and Insurers.
.Gov can bail out the pensions this time instead, or at least the pensioners.
People should look to Canada over the past 35 years to see an example of an economy where there was zero realized equity risk premium. It survived, although there are relatively few rich people there, and until recently, there wasn't a financial scammer on every streetcorner trying to take your money.
Probably good to own gold/silver and the miners in a rising interest rate environment. Raising the minimum IRR (MIRR) most profoundly has an impact on project feasibility, which ultimately serves to constrain supply and investment.
IDK kind of a compelling read but Ron Insana agrees to disagree...
that chart more closely correlates with the inflation caused by going full fiat than interest rates. if interest rates rise this time it will be because the dollar has lost its reserve status(the ultimate sanction) and the sandp will launch to the moon a la zimbabwe.
'Rising rates'....yea sure, I'll believe that fantasy when I actually see it...ZIRP 4eva.