It Is No Longer A Case of TINA (There Is No Alternative)

Since our last report the Federal Reserve has met, left interest rates unchanged, but consequently has made a lot of noise that at least two more interest rate hikes will be forthcoming.

Given tight labor conditions and the persistence of inflation,  one wonders why they hesitated, then thought differently, and have subsequently tried to make up rhetorically for what they failed to do.  But trying to divine what the  Masters of the Universe at the FED will do, is more than a cottage industry on Wall Street and we claim no great expertise.

While we acknowledged the undeniable better technical action in the stock market and added modestly to positions to accommodate that improved price action, we suggested that investors remain restrained because of narrow and distorted stock leadership (just seven giant tech firms accounted for 98% of the increase in the broad Wilshire 5000 Index), very high sentiment (investor enthusiasm has become dangerously excessive), overbought momentum, and a very muddled economic background.  We want to remain mentally open to further stock advances, but just remain unconvinced that “a new bull market” has commenced.

The reliance on “20% advance=new bull market” is in our opinion, an overly restricted view of things.  After all, there have been about a dozen rallies of 20% that were not bull markets.  In addition, enduring bull markets start from a level of market undervaluation and public despair, which is the opposite description of today’s market environment.

If we are indeed in a new bull market, broader participation must take place, and pretty soon.  Some widening has occurred but, the evidence is inconclusive.

Most stock indexes calculated without “the magnificent seven” are basically flat on the year.

That cannot be said for the falling bond market,  which moves opposite the direction of interest rates with mathematical certainty.

While stock action has been muddled after a strong start to the year, interest rates are rising and dropping bond prices in the marketplace even while the FED “paused” in executing its regime of tightening.

It would seem the market itself is doing what the FED failed to do, that is, increase interest rates.

Why the market would be doing this is a bit of a puzzle.  Inflation has been moderating but remains very sticky with a very tight labor market.  However, we think it has something to do with the “debt ceiling” agreement and huge government borrowing.  The government was basically out of the credit markets because of the debt ceiling dispute and now they are borrowing huge sums of money.  FED rhetoric is also an influence.  Whatever the factors that may be in play, interest rates in the marketplace are rising.

With the government issuing a huge supply of debt, and at the same time, the FED is shrinking its balance sheet (selling even more existing debt), the market will experience a huge increase in the supply of debt.  More supply without a corresponding increase in demand means lower bond prices, another way of saying interest rates will go higher.

This raises very important questions for investors: How long can the economy hold up with interest rates increasing?  At what rate do we hit an inflection point that starts to really damage commerce? How long and at what level will interest rates stop or reverse the short-term favorable trend in stock action so far this year?  Will the FED keep the pressure on too long and commit policy errors?

Unfortunately, we don’t know, and we don’t know anyone else who knows the answers to those questions.  But what we do know is that rising rates after an environment of easy money, and excessive credit expansion spurred by years of zero-rate policies, will likely uncover all the economic misallocations of capital that always occur in such periods of easy money.  Bad loans beget bad projects and both will likely have to be purged from the system.

Moreover, as economist Ed Easterling has pointed out, markets and the economy can adjust to both high and low rates, but what really causes disruption is a rapid rate of change in interest rates, and that has certainly been the case over the past year or so.

That is one of the reasons we advised only modest allocation changes and that caution should still be exercised.

So not only are domestic interest rates rising, most foreign central banks, unlike the FED, have been increasing their interest rates as well.  This means global conditions in the credit markets are getting tighter as well as here in the US.

As we write, the yield on the 1-year US Treasury Bond is now over 5.44%, breaking the line of resistance we see going back to 2006.

With a $32 trillion dollar debt, Uncle Sam is going to be paying a lot more in interest, which has the self-feeding effect of increasing the deficit even further (debt spiral).

Since this rate is considered “risk-free”, everyone else who wants to borrow will have to pay higher rates for the money they borrow.  This includes states and municipal governments as well as private industry.

There is a huge sea of variable rates mortgages that must be refinanced and many analysts worry about sectors of commercial real estate that must pay higher rates all the while vacancies rise (this is particularly true of office space) and sectors of the dying brick and mortar retailers continue to struggle.

The pressure from rising interest rates already has hit the banking sector and we have had three of the four largest bank failures in history, even with the economy doing reasonably well.   According to the Wall Street Journal, the government is in fact attempting to lure retired bank examiners back into action. It makes one wonder about what would happen if rates go higher and the economy were to turn down.

Rising rates we think are largely responsible for pushing gold back around the area of $1900.

Speaking of mortgages, the rate now for a 30-year fixed rate mortgage has risen to 6.8%percent, very near its high of last October.  This makes buying a home much more expensive and if we break into new highs, that could have psychological effects as well.

The one bright spot in this scenario is that for investors who desire lower-risk investment, the yield on short to intermediate US Treasury Bonds is much more attractive than they have been for quite some time. In recent years,  money managers would justifiably plead TINA (there is no alternative) which forced many to participate in an expensive stock market.  FED policies of low or zero rate interest rates all but destroyed traditional safe alternatives.  That is no longer the case and the higher rates go, the more attractive bond alternatives become.  Even if your timing is off a bit, if you buy shorter maturities you are guaranteed to get your money back at maturity.

While there remains a lot of liquidity out there because of excessive government spending, stock buyers cannot be assured it will all flow to their preferred investment.

There is one other sobering thought that bears consideration.  While rates are rising, it is occurring mostly in the shorter-term Treasury market.  As we said before, this will sooner or later cause everyone else to compete.  Moreover, shorter-term rates are rising above longer-term rates,  and this “inversion” of rates is unusual.

There have been only three times in history the yield curve has been this inverted: 1929, 1973, and 1979-80.  We lived through the last two and have read about the first one. It was not pleasant.

Historically speaking, inverted yield curves are a sign of credit distress and usually presage a recession. If the latter condition does prevail, it could make life difficult for both investors and political candidates in 2024.