Monday, June 17, 2013

The interest rate obstacle

It had to happen sooner or later.  After several months of near perfect fundamentals and technical strength the stock market is finally showing a couple of cracks in the edifice.  Granted these cracks aren’t yet big enough to completely jeopardize the interim bull market, but they are making their presence felt in the short-term trend.  Moreover, if left unchecked and not repaired, the cracks could eventually grow big enough to breaking the dominant intermediate-term uptrend for equities later this year.

The first crack in the wall is the fact that interest rates for corporate bonds and Treasuries have been rising steadily for the past few weeks.  While the rising interest rate trend isn’t sufficient or established enough yet to be a major threat to the stock market or the economy, it has the potential to create problems down the road if it continues.

The following graph shows the progression of the Dow Jones Corporate Bond Index over the last few months.  This has been the most precipitous decline seen in corporate bond prices in recent memory.  Corporate bond prices typically serve as a proxy for the stock market outlook, albeit with a lag. 

In many ways the rising rates (and falling bond prices) is beginning to resemble what happened in 1994 when a bond market sell-off added to the pressure of the S&L crisis to hit equities hard.  Not coincidentally the 20-year Kress cycle bottomed in late 1994 and is now entering its final “hard down” phase into 2014.

While there is still room for stocks to rally this summer before entering the anticipated volatility phase as we head closer to the 2014 Kress cycle bottom, the rising interest rate/falling bond price trend is a reminder that there’s still plenty that can go wrong between now and 2014 to upset the benign forecasts of the long-term bulls.

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