With the rising stock market, we are seeing rising interest rates as the 10-year US Treasury note has moved from 1.64% in the beginning of May, to 2.15% at the end of May. It is important to keep the inverse relationship between the value of bonds and interest rates in mind. This means that as interest rates rise, the value of bonds fall. Accordingly, in the last few weeks we have seen the values in bonds falling as rates have been rising. The recent action in the bond market has caused a great number of analysts, fund managers and the like to say that the 30-year bull market in bonds is officially over. No one can put their finger on a particular reason for the recent rise in interest rates. We can look at the global economy and find a few things pointing to higher rates such as the FED talking of slowing their bond purchases, a rising dollar, and uncertainty over Japan’s economic ordeal.
As mentioned above, there have been rumblings from FED officials about the need or desire to slow the amount of government and mortgage-backed bonds purchased. This alone would certainly cause a short-term lift in interest rates and drop in bond values. Looking out further, it is hard to see the FED allowing interest rates to rise given the anemic economic recovery. A surefire way to derail the hopeful recovery would be raising rates. The reality is that over the last five years the FED has sat on interest rates to push people to spend and invest in order to get the economy moving. Thus far, the stock market has been re-inflated and the housing market appears to be turning a corner. But, the one thing that the economy must see for economic growth is spending.
Economic data released at the end of May showed conflicting information. US personal spending declined, while US consumer sentiment rose. It does not make sense that consumers are as confident as they have been since 2007, yet they are spending less. This fact is thwarting the FED’s idea of the wealth effect, whereby people spend more because they feel ‘richer’ due to the increasing value of their investments and houses.
Our read is that the economy, stock market and housing market are all safely dependent on low interest rates. And, if the current inducements to spend have not worked, then more stimulation of the economy will follow. If history is any guide, and barring unforeseen economic disruptions, we are likely to see more of the same economic stimulus going forward only with less impact on the economy and investing markets. We are now at a point in the markets where good news is good, and bad news means the FED will keep printing.
It is true that in relatively short bursts, the markets and economic data points can diverge greatly. However, in the end, history shows that 100% of the time either the markets catch down to the economy, or the economy catches up to the markets. The problem, as we see it, is that the FED and global central banks have taken the markets to the proverbial moon; now the question is can they get us back to ‘normal’ in one piece?
Consider the current scuttlebutt in the world of finance which is the idea that the FED will ‘taper’ or reduce the amount of government bonds and mortgage backed bonds they are currently buying to support the economy/stock market, and suppress interest rates. The idea is that when the economy appears to be good, the FED will take off the market and economic training wheels. Typically, a good economy warrants higher interest rates. Since the FED has been suppressing interest rates for so long, it is likely that rates will rise faster than hoped or expected (uncoiling), and/or there will be a dramatic drop in stocks. The reality is that the investing markets do not appear to be ready to price in a reversal of the FED’s actions gradually. Consider the chart below that shows the correlation of the FED’s balance sheet and the stock market as represented by the S&P 500 Index.
Understanding that the FED (and global central banks) have been fueling the markets, it would be realistic to think that a reversal of global central bank actions will cause the reverse. For this reason we will be watching the central bank balance sheets ever more closely.
Do you have an investment strategy that seeks to protect your portfolio against volatile economic conditions? Call me to schedule a free review of your current investment portfolio – 913.402.6099.
John P. Chladek, MBA, CFP® is the President of Chladek Wealth Management, LLC, a fee-only financial planning and investment management firm specializing in helping families and couples who are not yet retired realize their financial goals. For more information, visit http://www.chladekwealth.com.
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