Despite
its intent to boost asset prices and restore the economy, the Federal Reserve
has run into a major obstacle in achieving that goal. This obstacle is serving as a reminder that
ultimately the long-term natural cycles of inflation and deflation govern the
market and that intervention will usually fail.
That
major factor that is engineering the Fed’s eventual defeat is the 10-year
Treasury Yield Index (TNX). The rally in
Treasury yields from May through September took a lot of steam out of the
financial market. The industrial stocks
were heavily affected by rising rates as can be seen by the volatile
performance of the Dow Jones Industrial Average (below). The reason is that the industrial sector is
much more sensitive to changes in interest rates than the tech sector.
The
reason why rising interest rates are a potentially serious problem for the
economy – as well as a stumbling block for stocks – is explained by Chirantan
Basu of Zacks: “Rising yields lead to higher mortgage interest
rates…. Higher mortgage interest rates mean higher monthly mortgage payments,
which slows down the real estate market as home buyers put off buying new homes
or upgrading to larger homes. This drop in demand could depress home resale
values, which leads to a drop in household net worth. People feel poorer and
less optimistic about the economy, which usually means they spend less on
non-essential items.”
Some economists are trying to underplay the
effects of rising Treasury by claiming higher yields reflect a stronger
economy. While this may true in normal
cases, the present case isn’t one of them.
Treasury yields started rising soon after the Fed telegraphed its
intention to begin tapering QE. Since household
borrowing for consumption is the lifeblood of developed economies like
the U.S., higher rates are a major point of concern and can’t be underestimated. Rising yields are also the point where the bond market starts
to influence and limit U.S. central bank balance sheet expansion due to the
increased cost of debt.
Another point worth
discussing is that while rising yields may have reflected an improving economy
in the “old days” before widespread globalization, the relationship between
yields and economic performance is much more complex today. Alen Mattich, writing in The Wall Street Journal, observed that rising Treasury bond yields increase
yields across other sovereign debt markets, thereby tying the hands of central
bankers. He points out that Bank of
England Governor Mark Carney recently made clear that rising U.S. yields were an
unwelcome complication for the U.K. economy.
“Unfortunately,” writes
Mattich, “other central bankers will find it hard to battle against U.S.
headwinds, if only because by trying to keep downward pressure on domestic
interest rates, they also run the risk of triggering a currency crisis.”
In
recent weeks I’ve mentioned the importance of the 90-day moving average with
regard to the Treasury Yield Index. In
recent months pullbacks in TNX always found support somewhere above the 90-day
MA, including most recently in early October.
On Oct. 17, however, TNX broke decisively under the 90-day MA as you can
see here. This indicates that the
Treasury yield has lost much of its former upside momentum and is now weaker
than it was this summer. This in turn
should take some of the pressure off equities and make it easier for stocks to
rally in the near term.
My
best “guesstimate” in terms of potential downside for TNX is that the index
should decline no further than approximately the 25.00 level as shown in the
above chart. I’m guessing we’ll start to
see support becoming established for TNX in the next few weeks yields grind out
a lateral trading range. In other words,
despite the recent weakness we may not have seen the end of “high” yields.
Another
factor working against the Fed’s attempt at creating asset price inflation is
the proverbial cockroach in the casserole, namely the anticipated end to
QE3. For months investors have nervously
awaited the Fed’s official announcement as to when quantitative easing will
finally be “tapered.” The Fed has been
sly with its handling of this issue, first getting investors used to the idea
of the coming end of QE, then surprising everyone by announcing its
continuation. This tactic can be
interpreted as a form of financial market engineering in itself, although
that’s beyond the scope of this commentary.
Even
if QE continues into 2014, consumers, mortgage holders and businesses will
continue to act as if the end is imminent.
As Ramesh Ponnuru has pointed out, “When the Fed creates an impression
about future spending levels, it affects the spending that people undertake
today in anticipation of that future. So
when the Fed suggests that it will pursue a tighter money policy in the future,
it is effectively tightening money in the present.”
The
point is that the gorilla is out of the cage and investors know that QE’s days
are numbered.
