The stock market has been wobbly lately, up 100 points one day, down the same the next day. What’s going on? It’s the expected future direction of interest rates that’s spooking the market. After all, it’s the direction that matters, not their overall level. Given that the market seems to believe that rates will soon begin to rise, you should expect a significant stock market correction shortly. Well today it dropped 2.5% so that gives you a taste of what’s to come. Similarly, bond prices have dropped too lately.
What Factors Determine the Direction of Interest Rates?
Two main reasons explain the future path of interest rates; the real cost of money, and expected inflation rates. The Fed has kept the cost of money artificially low for several years. However, they seem to be suggesting that this program may end by 2014 and the market is beginning to anticipate this action. Furthermore, the Fed this week predicted that the economy will grow more than expected just a few months ago, which ads pressure to interest rates.
On the other hand, inflationary expectations are very low presently. With commodity prices dropping across the board, unemployment relatively high and the major economies in the world displaying weak growth, inflationary expectations will remain low for now. This will keep a lid on the size of increase in rates.
Which Is the Better Predictor: Stock Prices or Interest Rates?
Stock prices and interest rates can predict future economic activity. What are they telling us now? The rise in the stock market this year (ignore the last few days) suggest that the economy will continue to get better. On the other hand, the historically low level of interest rates seems to predict a poor economy. Let’s analyze this dichotomy for a moment. If the stock market is right, these low interest rates are a mirage. The ten year Treasury should be closer to the 4-6% range. Therefore, if this view is correct, you can expect bond prices to drop dramatically, and their total rate of return to become very negative for this year.
However, if interest rates are the better predictor, they suggest that the economy will continue to grow poorly and there is the possibility of a deflationary move and a “lost” decade as characterized Japan for the last 15 years. Therefore, if this interpretation is correct, the run up in stock prices is misleading and you can expect a major correction in prices. Today, with the stock market down 2.5% is a good sample of this.
I am convinced that interest rates will be moving higher due to two main reasons: the growing economy and the phase out of the Fed’s massive bond buying program. This rise will cause large losses to the market values of bonds, and should lower stock prices because their values are directly tied to the level of interest rates.
The evidence seems to be confirming my belief. For example, when I wrote my last newsletter on May 15 (a little over a month ago) the rate was 1.81% and today it closed at 2.4%. This means that rates have risen more than half a point, an augur of what’s to come. This increase has resulted in drops in prices of both bonds and stock prices over the last few days.
When will it be time to start purchasing bonds? I would act quickly when the ten year Treasury approaches 4%. It may take a while, but we will get there. When will it be time to start buying stocks again? Let’s wait and see how events materialize.
All in all, this is the time to be conservative and certainly cautious.
In today’s market, many investors are unsure just what to do. If you run into someone like that, I’d like to help. So, would you be sure to ask them to call me at 714.771.6000. I’d very much appreciate the referral.