The Problem Lurking Under the Surface

It isn’t hard to put a list together outlining the challenges that this country faces. Probably my top 3 on a list would be unemployment and the government’s inability to do anything about it, the trillions of dollars worth of debt not just here but all over the world, and then the foreclosure crisis.

What isn’t getting much attention is the problem that is lurking under the surface. It is also the one issue we want to keep under control. So far, the government had been able to manipulate interest rates to the point where they have been kept under control.

The picture above shows the 10 year treasury interest rate between 1962 and today. You can see how rates went real high during the 60’s and 70’s. Then in 1980, interest rates started to fall. For 30 years interest rates have fallen. In 2008, they hit the lowest level. As of late, it looks like rates could be heading back down to those levels. Currently, we are 20% above those low interest rate levels in 2008. Since April 10th of this year, the 10 year treasury rate has fallen -32%.

Remember that interest rates and the prices of bonds move in opposite directions. While interest rates are falling, bond prices are rising.

As I wrote in this article, my concern is that we have a huge bond bubble forming. A bubble occurs when everyone invests into some sort of investment because collectively they think that this is the best place to be. In this type of environment, investors just cannot get enough. They do it in such a large way that the price of the investment gets way out of line with its true value. At some point, the bubble bursts and prices come back down to their real value. Just think about what has happened to the prices of real estate after the real estate bubble popped.

Here are a few bubble facts for you:

Last year, 375 billion dollars was invested in bond funds. Between 1998 and 2008, 425 billion was invested in bond funds. In one year investors poured almost as much money in bond funds as they did the prior 10 years.

Last Friday, the Wall Street Journal reported that companies are on pace to have a record year in issuing junk bonds. Investors are flocking to the riskiest bonds issued because they can get higher interest rates or yields.

It looks like we are experiencing bond fever on Wall Street. The problem is that if the bubble bursts, then that means interest rates will soar. Soaring interest rates is the last thing that we need in a world plagued with debt. The Federal Reserve Board knows that and because of that fact have done everything humanly possible to manipulate the prices of government bonds. Let’s just hope that this grand experiment works.

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Trust Me, You Want to See Inflation

Bloomberg had an article posted today entitled – Bond Traders Declare Inflation Dead after Yields Fall!  The article surmises that interest rates are low and well contained.  One trader states that he is not concerned at all about rising interest rates.  He doesn’t think that rising interest rates will be a threat.

I believe that interest rates will rise for one simple reason.  Let me show you an illustration of something that ran in the Chicago Tribune.

(related image) 

Debt will probably be the reason that interest rates go up.  If you have been staying up on the news, you know that Greece and many of the other European Union countries are in financial trouble.  Greece, in particular, needs to borrow money or are seeking a bail-out just so they can make their debt payments to their creditors.   So if you are going to lend money to someone in trouble, shouldn’t you get rewarded with higher interest rates for taking the risk?  When Greece issues bonds (read: borrows money), they are forced to pay higher interest rates because they represent a risk.  I think that we will start to see the same thing in this country.  In fact, I think that we already are seeing this occur.  At some point, investors are going to demand much higher interest rates on US government bonds which forces interest rates to rise.  One other point to make about the article is that rising interest rates does not automatically equate to inflation.  We need prices to go up all across the board for inflation which brings me to the title of this piece.

Inflation would be a welcome sign.  The opposite of inflation is deflation.  That is what Japan has been mired in for decades and what the US went through in the 30’s.  I believe that is what we face today. Unusually high levels of debt create deflation.  So, once again, we come full circle to this enormous debt problem in America.  Our politicians can pretend it is not there.  We can also think of it as our children’s problems.  In reality, it is driving force behind all financial problems in this country.

Low Volume

Will Deener wrote an article in the Dallas Morning News this morning debunking the views of those of us who are bearish.  He quotes a trader that states the low volume in the stock market is actually a bullish indicator.  He says that you want to buy stocks when no one wants them.  I don’t think that I would go this far.  There is something else that usually occurs when the volume is this low.  You typically see low volume when you are getting to the end of a bull market run.  Further, investors are unusually spooked right now about the stock market.  I don’t think that this kind of fear is a good thing.

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Are the Future’s Problems Starting to Look Like Tomorrow’s Problems?

How does the market keep going up when we are racking up all of this debt?  How can the market be positive with a shaky future of trillions upon trillions of dollars of debt?  Well the key word has always been in the future.  That big debt problem has always been looked upon as a problem that our kids are going to have to contend with.  

As long as the Government continues to finance the deficits, everything will be OK.  What if we are getting to a point where financing debt becomes the problem?  Well, I see it becoming a problem in 2 phases.  The first phase has to do with our potential lenders.  In the past, other countries have been willing to lend to us.  Today, they are demanding higher interest rates for loaning the US money.   The second problem occurs when even higher interest rates do not even matter.  A serious loss of confidence has occurred.  We just cannot get enough money borrowed to cover the problem.

 

I think that last week we saw phase 1 occur for the first time.  Last week, we had 3 big treasury offerings.  The demand to buy our treasury bonds was very weak.  As a result, we started to see interest rates climb.  Rising interest rates in a debt-filled world is problematic.  For one thing, this has an indirect effect on mortgage costs.  In order to lessen the severity of the foreclosure crisis which has a direct effect on whether or not the real estate markets ever bottom, interest rates need to stay down and not rise.

 

One other interesting development is that investors are being paid more for holding treasuries than in corporate bonds.  You see this in the interest rate swaps market.  This signals that investors feel more confident and that they are taking less risk by holding corporate bonds rather than those of the Government.

 

One of the downsides of this healthcare bill passing is the publicizing of the additional financial burden this is going to create in the future.  This brings the reality of our trillions of dollars of debt to the fore-front.  Don’t for a minute believe that this will cut the deficit.  The CBO’s analysis is performed using government accounting and “estimates.”   When has the Government ever gotten an estimate correct?   Then you have Greece showing us what our future more than likely looks like.  All of that gives investors a reality check and makes them think twice before loaning more to the government.   

 

Watch the interest rate on the 10 year treasury bond.  Below 4% we are fine.  Above 4% creates a dicey environment.  As I write, we are dangerously close that level. 

Incidentally, the Government has to raise 1.6 trillion dollars to cover the short-falls for the year.  That is on top of the 2 trillion that needs to be refinanced this year.  

 

On a Lighter Note…

How about this for a vote of confidence for the politicians?  Since 1897, a year after the Dow Jones started, 90% of gains came on days when Congress was out of session.  This body of research also looked at how investments would have performed while investing in the days that Congress was in session and out of session – The out of session investments strategy had investment returns 100 times greater than when Congress was in session.

 

 

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What the Government Bond Markets are Saying About Stocks, the Dollar, and Gold

Did you ever wonder why mortgage rates have been so low this year?  Well, let me take you on a journey.  Mortgage rates are influenced by government bond interest rates.  Government bond interest rates are influenced by the price of Government bonds.  If bond prices go up, then interest rates go down.  In order to raise the money to pay for all of the irresponsible spending of the Government, the Treasury sells Government Bonds.  Institutions, other countries, investment firms, etc. buy the bonds from the Government.  That money then goes to work to pay for all of the spending created by the Government.

The Government has a lot riding on those government bond sales or auctions.  If they go well, the Government sells the bonds and gets the money, bond prices go up, and interest rates stay low.  Since most people don’t want to lend the US money because we are in so much debt as it is, someone had to step in and help buy those bonds.  Yes, the Federal Reserve Board has been buying bonds all year creating more debt and keeping bond prices higher and interest rates lower.  I will not even go into how incredibly irresponsible it is for the US to buy its own bonds.  That goes without saying – the problem is that program is coming to a grinding halt at the end of this week following the largest bond auction on record this week – 123 billion dollars worth of government bonds to be issued.  The Fed will get out of the way and the bond markets will be allowed to function freely again.  That might not be so good.

Interest rates started going up today and are at a 2 month high.  What happens when you suppress something that should be going up and then stop?  It is like compressing a spring.  If you let go of the spring, it takes off.  I think that the same thing could happen with interest rates.  If this happens it could disrupt the credit markets, consumer interest rates will go up, businesses will have even more trouble borrowing money, and homeowners will now have trouble getting low cost mortgages. 

The stock market would have a tough time with raising rates.  However, the rising interest rates should help the dollar. If the dollar is going up, the price of gold should take a hit.  Welcome to Deflation!  The economy might start the debt detox process that should have started when this crisis started. 

If you are looking for a catalyst, this could be it.  Interest rate risk is not something that the stock market is ready to face.  However, China and others would certainly like to see the value of our dollar go back up.

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Corporate Insiders Are Very Bearish

Forget about what the Government, Wall Street, or the economists say about the probabilities for the stock market and the economy.  Instead, look at what the people in the day to day trenches are doing with their money.  A key indicator is the actions of the corporate insiders and whether they are buying or selling their company stock.  Think about it for a moment.  If the corporate insiders, the individuals who are seeing the actual numbers and projections for the future, are selling their company stock, then there is obviously something that concerns them. 

According to Wall Street, this is intended to be the buying opportunity of a lifetime.  If so, then why would you sell?  Let’s take a look at the latest statistics that show whether corporate insiders are positive or negative about the future.

In the last few weeks, corporate insiders sold over $335 million in stock versus the buying of only $12 million  (www.financialarmageddon.com).  This begs another question. Is it more concerning that insiders are selling or that insiders are just not buying?

The reality is that the economy is not in good shape and the fundamentals do not suggest that we are remotely close to being out of the woods.  Let’s take a look at a few other variables.

Unemployment

I wrote last Friday about the huge discrepancy in the unemployment report that the Government gives and the unemployment problem that is really facing America.  However, the numbers get even more distorted when you consider other variables.  The temporary workers distort those numbers.  This is the classification of workers who are jumping from temp job to temp job just to make ends meet.  They will count as employed.  The latest shadowstats.com repoprt shows the unemployment number around 20.5%.  That is a far cry from the reported 9.4% unemployment and suggests that a huge headwind faces this economy.

Interest rates

The Government is going to have a tough time getting this economy jump-started if interest rates continue to increase.  This is going to be a key risk factor for the stock market.  This week the Government will be holding another significant bond auction in order to raise money to fund our enormous spending appetite and deficits.  Buyers are demanding higher rates of interest for the bonds thus increasing the interest rates of the government bond markets.  Interest rates were up again last week.  Of course, this affects the interest rates of the consumer markets.  The last thing that a debt crisis needs is rising interest rates.

Price Levels

Let’s not forget the price levels that we watch to determine if the market is making headway and still a good investment or if the risk level has become too high.  The price level of 943 is a huge price level that the S&P 500 has had a tough time getting over.  The longer that the S&P 500 stays below that price level, the larger the chance that the bear market declines will return.  Thus far, this has been a real challenge for the market.

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Market Outlook Schedule

I am going to be out of the office Wednesday through Friday with my family for Spring Break.  I will be posting a pretty intense analysis on Monday of next week.  There is a chance I might post more information at some point during the week on some downtime so you might check back.

For the remainder of the week, this should get very interesting.  The S&P 500 is at some pretty signficant price levels right now.  If they can move above these price levels, the S&P 500 should definately be at the 800 to 825 level before you know it.  There is a good chance that could be the top of the bear market rally.   We  are already up 16% from LAST MONDAY.  This market is volatile.

So, you know the price levels.  Anything over the price level of 800 to 825 is positive.  Anything below the price level of 741 is negative.  Said another way, risk starts to reduce as the market closes above the price level of 825.  Risk starts to increase as it falls below 741.

The Federal Reserve Board Meeting is tomorrow.  There will nothing done with interest rates at zero.  However, the Fed statement will be important.    There is also another event taking place on Friday called “options expiration” that typically makes the week very volatile.  I will explain that at a later time.

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