Friday, September 26, 2014

stocks and interest rates

I want to make a few comments on interest rates today but before I do I think the situation in the US stock market indices merits close attention.

Yesterday the S&P 500 closed below its 50 day moving average. The NYSE advance-decline line had been below its 50 day average for several days previously. The Dow closed just a tad above its 50 day average yesterday. This puts two of my three main trend indicators below their 50 day averages. As a rule this sort of bearish configuration is followed by a return to the level of the 200 day moving averages. The S&P's 200 day average is currently at 1898 while the Dow's is at 16,550.

There is always the possibility that yesterday's selling spasm was climactic in nature instead of a downside breakout. If it is a breakout the averages should close below yesterday's close within a day or two and keep going down. But if instead we see strength above today's high (whatever it turns out to be) early next week I will probably conclude that the bearish indication I think I see now is really a fake-out and that new bull market highs lie ahead.

Now to interest rates.

There is no question in my mind that the quantitative easing programs implemented by the Fed, the Bank of England, and belatedly by the Bank of Japan and the European Central Bank are responsible for a good part of the bull market advance in world stock prices during the past 5 years.

These QE programs all share a paradoxical feature. Purchases of fixed income assets tend to lower interest rates, other things being equal. In the short run other things are equal and the immediate effect of these programs is indeed to lower interest rates.

But the long run effects of successful QE programs are very, very different. The primary determinant of interest rates is expectations about the rates of economic growth and inflation. Taken together these constitute a forecast of future growth rates of nominal gross domestic product (no inflation adjustment). The whole purpose of QE programs is to raise expectations about the rate of growth in nominal GDP and, of course, to then have these expectations fulfilled.

A good rule of thumb to remember is that low interest rates are associated with weak economies and/or very low inflation rates while high interest rates are associated with strong economies and/or high rates of inflation. So a successful QE program will necessarily be followed by rising interest rates as the nominal rate of economic growth increases. This effect will be quite independent of central banks' short term interest rate policies.

Keeping these observations in mind take a look at the monthly bar chart at the top of this post. This chart shows the yield of the 10 year US treasury note.

The Fed pursued three distinct QE programs since 2009. The first two were temporary, had definite end dates, and consequently had limited effects. But in September of 2012 the Fed began an open-ended QE program which it said would continue until the states of the labor market and economy were restored to "normal". This was a very strong commitment to economic growth going forward. Only recently have economic conditions improved enough to allow the Fed to wind down its QE program.

For these reasons I think we have seen the low point in 10 year yields in the current 60 year interest rate cycle. The last low point in this cycle occurred just after World War II while the subsequent high point occurred in 1981 amidst world-wide inflation problems.

If I am right about this then I think the 10 year yield will trend gradually higher over the coming decades (!). Looking ahead for the next year or two I think this yield has a good chance to reach the 3.80-4.00%  zone (purple oval). There it would have reached the levels last seen in 2009-11 (red lines). A move up  in yields from the August 2014 low which matches the size of the move up in 2012-13 (blue rectangles) would put the 10 year yield in the same zone. Note that the upper parallel green trend line reaches this zone near the end of 2015.

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