Great video on how a economy works On My Radar: Jalapeño Peppers & Interest Rates Share This: Share on linkedinShare on facebookShare on twitter October 18, 2013 By Steve Blumenthal For now, interest rates look to be range bound between 2.40% and 3% as illustrated on the following chart. Which way are they headed and what should we keep our eyes on? In today’s piece, I share some thoughts around the direction of interest rates and portfolio positioning. It is 3:00 am Seattle time and my east coast clock is turned on. Yesterday, I presented at the Bloomberg Masters Class on ETFs. Bloomberg hosts a number of ETF conferences around the country and invites anyone who uses a Bloomberg terminal to attend. If you’ve seen the Bloomberg building in NYC, you know there are a lot of Bloomberg terminal users. We (me and my research team) are certainly addicted to ours. The conference was packed and the audience was super smart. After the conference, it was sushi, chicken wings and bacon jalapeño peppers at a sports bar called the Tap Room. A few of the panelists, along with a very loud Seattle Seahawks crowd, watched the home team win. The peppers were good but maybe that’s why I’m up so early! The big question on everyone’s mind was interest rates. So let’s take a look. This week, I share the following relevant research: Inflation and the Direction of Interest Rates Debt – The Problem is Debt (This Chart Tells the Story) How The Economic Machine Works – Ray Dalio Trade Signals – Investor Sentiment and Cyclical Trend Charts Continue to Remain Favorable Inflation and the Direction of Interest Rates 10.18 img 1 While there are other drivers that impact the direction of interest rates (like deteriorating credit, supply/demand and Fed manipulation), over time, inflation remains the most important driver as shown in the next chart (courtesy again from NDR). 10.18 img 2 So, we carefully watch inflation. While risk and Central Bank behavior favors higher inflation long term, that risk is likely to develop slowly. Wage pressure is a contributing source to inflation and something we should watch closely. The next chart shows we are not yet seeing any material wage pressure in employment (red line). As we have noted in past pieces, personal consumption remains low (blue line). 10.18 img 3 Actual Inflation is lower than Expected Inflation. 10.18 img 4 Real income remains squeezed. The middle class is hurting and unemployment remains an issue as measured by our friends at shadowstats 10.18 img 5 Increased wage compensation can push up inflation gradually, but with relatively high unemployment there is little wage pressure today and, as brilliantly presented in the Dalio piece below, we remain in the debt-deleveraging part of the longer-term business cycle. It is difficult to sustain a higher level of inflation unless the economy grows above trend and we are currently in a below trend environment. Further, due to regulatory changes, the credit creation process has been impaired. Basel 3 requires higher capital ratios and Dodd-Frank will require 5% equity stakes for securitized non-qualified mortgages and the posting of margin on derivatives transactions. Unemployment, low wage pressure and the lack of credit creation all serve to inhibit inflation. The deflation/inflation game plays on. Deflation has the upper hand right now but the Fed is a determined player. So where do rates go next? According to our conference host, Ray Johnson of Bloomberg, most analysts see the 10-year rate at 2.85% to 3% by the end of 2013 and 3.85% by the end of 2014. If global growth picks up, I think we could see 3.50% in 2014. Remember this is where yields were in 2011 just before the S&P downgrade of US debt and is probably considered a normalized level by most economists. My two cents is that it is going to be a choppy ride. Can the global central banks balance the effects of new money creation against the effects of a debt-deleveraging correction cycle? Game on. Ultimately, I think they will succeed in their desire to create inflation. I am a short-term bull (lower trend in rates) and a long-term bear seeing higher interest rates in the years ahead with significant indigestion in between. Stay nimble and tactical in your approach. We can only watch and see how the game plays out. Debt – The Problem is Debt (This Chart Tells the Story) Note the impact on growth when debt is high. Real GDP at just 1.8% and Nonfarm Payrolls at just 0.4%. 10.18 misc To better understand how debt factors into our lives and effects business cycles, grab a coffee tomorrow morning and spend 30 minutes watching Ray’s masterfully done piece on how the economic system works. How The Economic Machine Works – Ray Dalio Ray runs Bridgewater Associates, which is the world’s largest hedge fund. Please share this with everyone you know especially your friends in Washington. (To my good friend and old college roommate, Congressman Charlie Dent, watch this and share it with your congressional colleagues. Many are attorneys and life-long politicians but few are businessmen. They need to know how their actions impact the system. His nickname was Chuckles in college. He was always smiling. Go get ‘em Charlie). I was asked by a Seattle advisor where I think interest rates are headed and how I would position a client’s fixed income allocation today. I told the advisor that I believe rates are ultimately heading higher. Debt is the problem and a war is being waged to fight the deflationary debt deleveraging cycle we are in. Global central banks are doing everything they can to counter this by printing unimaginable amounts of money. Their goal is to create inflation and I believe they will win. I said that because we are now at such low interest rates, the economy remains fragile at best and we are going to be yelling for Yellen to print. I think she will. So will Japan, China, the EU and the UK. The 10-year Treasury yield might go to 2% before it goes to 4% but I believe it will be at 4-5% in three years or so. Not unimaginable when you look at the chart at the top of this piece. Do you remember the pre-sub prime environment? I later asked one of the attendees, “Imagine you were short sub-prime in 2007. You were on your way to getting rich. Could you have stayed the path looking at monthly statements that showed you were down 20% while the rest of the market was up 20%?” A number of peopled bailed out of that trade and raced back into equities. They reasoned that the housing market had never declined. A bad move. The house of cards came crashing down. Their equities declined 50% and if they had stayed short that sub-prime investment, they would have gotten rich. The same scenario is happening today if you short government bonds. You might go down before you gain. Since rates are so low, the short-term moves in rates have a much greater impact on return. We are in an ultra low interest rate/deleveraging environment that requires us to think differently than we have in the past. I recommend a few ideas: Shorten exposure and be patient. Think about a maximum of two to five year duration. Add unconstrained bond funds into your fixed income mix of assets. Add one or two core, tactical, relative strength fixed income ETF strategies as well. There are a few very good ones and it is easy to gain access. As I travel the country and meet thousands of investment advisors, it is clear to me that there is a knowledge gap that is beginning to be filled. A much broader set of portfolio tools exist and Bloomberg is doing an excellent job leading the education process. Thankfully we all have access to an abundance of research for free with the simple click of a mouse. Seattle is a great city and I must say the Seahawks’ fans are a lot friendlier than my home team fans. Do you remember the Santa Claus incident at the Philadelphia Eagles game a number of years ago? Snowballs…ugh. Please feel free to share this piece with your clients if you find it appropriate. They can also go to cmgwealth and put their email address in at the bottom of the home page to sign up. Have a great weekend! With kind regards, Steve Stephen B. 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Posted on: Mon, 21 Oct 2013 19:45:26 +0000
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