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Market trends are overwhelmingly powerful; an excellent reason the Fed is a follower of trend, not the trend setter.

Markets Move; Fed Does Not

October 5th, 2015 by Kurt L. Smith
  • We have witnessed a reversal from the slow and steady rise of the stock market to greater volatility including a twelve percent decline in the Dow in a mere four days back in August.  Stocks recovered going into the Federal Reserve’s interest rate announcement September 17th, yet the Fed chose not to move on interest rates.

    Long-time readers know my opinion on Fed activity (or inactivity): the Fed is a market follower.  We glean insight from what the market is telling us; so does the Fed (evidently).  We should watch the market, not the Fed.  The bottom line remains that interest rates are trending higher and some, particularly the shorter term interest rates seemingly most influenced by the Fed, have been trending higher for YEARS.

    Two year US Treasury notes traded at a low of .14% in September 2011 (interest rate figures per Bloomberg).  Before the Fed announcement on September 17th, the notes traded at .81%, a post-trend change high.  Longer-term bonds are all trending to higher interest rates (lower prices) and the implications for investors, I believe, continue to be quite large.

    Some investors, notably Bill Gross, believe the Fed missed its opportunity to raise interest rates earlier this year.  In his September 2nd Investment Outlook, Big Bill believes that rates “should be closer to 2% nominal, but now cannot be approached without spooking markets further and creating self-inflicted ‘financial instability.’”  I agree, though we now know that it was the Fed that was spooked by the market, not their fear of spooking, that kept the Fed on hold.

    Indeed, the Fed’s announcement on September 17th, while stressing its dual mandate of maximum employment and price stability (inflation), the Fed also noted that “recent global economic and financial developments may restrain economic activity somewhat” and  therefore “policy accommodation” continues to be warranted.  Additionally the Fed said it would “take into account a wide range of information” including “readings on financial and international developments” in determining the Fed’s future moves (or non-moves).

    Bottom-line, the Fed watches the market and the Fed is concerned.  If the Fed is concerned, I reiterate that I believe you should be concerned as well.  I have stated my concerns month after month of late and once again the Fed is a follower…of me, I mean, the markets.

    The bond market, which I said upon publication of my August Letter on August 12th was poised to move to higher yields and lower prices has done just that.  The thirty year bellwether Treasury bond traded at 2.72% on the 12th, bottomed at 2.62% on August 24th, traded as high as 3.09% on the 16th.

    In my opinion, this bond market move is the beginning of a much larger move that will surprise, well, just about everyone.  If the thirty year bellwether treasury bond trades at 2.75% at year-end, the price will be about twenty percent lower than it was on August 12th.  If the ten year US treasury note trades at 2.75% at year-end, the price will be about seven percent lower than the 2.15% yield on August 12th.  More importantly, the trend to higher rates would be continuing and this would also be of concern for the bond market.

    My forecasts do not depend on either inflation or deflation.  For the better part of thirty years, the bond market feared inflation as the evil that erodes bond prices.  There is essentially no inflation, by any measure, yet bond prices are trending lower rather than higher.

    Such low-to-no inflation should be of great encouragement to those in the deflation camp.  Deflation minded bond investors believe the lack of inflation will be positive for bond prices, particularly long-term US treasury bond prices.  Once again, sorry to disappoint you.

    Such concern over the trend of long-term bond prices has led a few to believe that the next interest rate move by the Fed may actually be to lower interest rates.  This may turn out to be correct, but it will not change the fact that the bond market is trending to higher interest rates and lower prices.   Market trends are overwhelmingly powerful; an excellent reason the Fed is a follower of trend, not the trend setter.

    The relative calm of the markets these past several years is now (obviously) over.  I do not expect this volatility to dissipate.  I expect volatility to become greater as bond prices continue to fall and stock prices gyrate.  The waiting is over and as more and more investors recognize the new trends in the market, I expect significant market moves to result.

    Lower bond prices, lower stock prices and lower foreign currency prices should be the next mile post that we are moving down the road rather than just kicking the can down the road.  Cash and cash alternatives will continue to grow in importance as safety becomes the watchword.  We are prepared for the move and my hope is that you are also preparing.

    University of North Texas Refunding

    Moody’s Aa2 Fitch: AA

    Due 4/15 Dated 10/1/15 Maturity: 4/15/2045

    Sale Amount: $105,130,000

    YEAR MATURITY COUPON YTM*
    1 2016 2.00% 0.17%
    2 2017 5.00% 0.59%
    3 2018 5.00% 0.88%
    4 2019 5.00% 1.12%
    5 2020 5.00% 1.37%
    6 2021 5.00% 1.62%
    7 2022 5.00% 1.84%
    8 2023 5.00% 2.03%
    9 2024 5.00% 2.20%
    10 2025 5.00% 2.32%
    11 2026** 5.00% 2.49%
    12 2027** 5.00% 2.62%
    13 2028** 5.00% 2.72%
    14 2029** 5.00% 2.83%
    15 2030** 5.00% 2.92%
    16 2031** 5.00% 2.99%
    17 2032** 5.00% 3.05%
    18 2033** 5.00% 3.10%
    19 2034** 5.00% 3.14%
    20 2035** 5.00% 3.19%
    21 2036** 5.00% 3.25%
    22 2037** 5.00% 3.28%
    25 2040** 5.00% 3.37%
    30 2045** 5.00% 3.44%

      *Yield to Worst (Call or Maturity) **Par Call: 4/15/2025

    Source: Bloomberg

    This is an example of a new issue priced the week of 9/28/15

    Prices, yields and availability subject to change

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