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The One Scary Factor

FYI | Mar 21 2018

By Peter Switzer, Switzer Super Report

The one scary factor that hurts my optimism for stocks!

The one thing I worry about when I think about my positive view for stocks is that crazy creature called the bond market. I think this market is loopy at times but the overall consensus of the professional players is “you ignore the bond market at your peril.”

My historical view on the bond market is that it can get it wrong in the short-term but, over time, it seems to be on the money.

The bond market talks

It’s why I started my first Money Talks program for 2018 on the Sky Business Channel on Monday nights with an in depth look at what the bond market was telling experts like UBS’s Anne Anderson.

She was wary of the bond market signals but still admitted she was long stocks! A bond junkie invested substantially in stocks was a nice revelation.

Don’t forget the bond market did try to tell us that US deflation was coming, reflected in interest rates, but the US economy did prove its critics wrong and has created growth with a pretty good chance of producing some decent inflation.

Right now the bond market is looking closely at every economic indicator and US Government policy, as well as the actions of the Fed, to try and guess the future movements of interest rates. Everyone knows it will be up, but it’s the pace of the rises that are critical right now.

A month or so ago when Wall Street lost over 10%, driving its stock markets into correction territory, the story was driven by great job numbers and faster than expected rises in wages. On the back of these numbers the bond market jumped into action, driving yields up, and when interest rates on bonds go up, stocks lose some supporters.

In the early rounds of rate rises the loss of stock supporters is manageable for stock markets. Even though stock prices can fall, bargain hunters, who think it takes some time before a huge exit from shares happens, return and keep pushing equity prices higher.

This is the phase we are in now and so if we could perfectly work out the course of interest rates over the next two years or so we could determine the best time to get out of stocks, or take positions to protect us from a sell-off.

The RBA view

With this all in mind, let me share a revelation from the Reserve Bank last week that should not be ignored.

The warnings about what the bond market might be up to came from the very smart Guy DeBelle, who is deputy governor of the RBA. He reckons rising global interest rates could be bad news for both stock and property markets.

You could be saying: “Well der” but when central bankers venture out of monetary policy into market prognostications, well I like to hear more, if only for money-making or money-protecting reasons.

He sees two big developments that could take away the calm that financial markets have delivered in recent years.

First is the fact that central banks are easing up on their bond-buying programs. These effectively threw money at economies to beat depression/deflation concerns and kept interest rates low.

Second, the United States, under Donald Trump, is going for a bigger budget deficit, creating more demand for money at a time when central banks are pulling back supply. Donald’s deficit to GDP is on track to be 5% and that’s big!

This is why bond market experts know where rates are heading but they are still trying to work out how fast they will rise. DeBelle said the US, Japan and Europe will be selling debt (bonds) which means they drag money out of the economy, and this has not happened since 2014.

DeBelle thinks a lot of big institutional investors currently think low interest rates will be here for some time. They expect a gradual rise, as do I, but you can never be complacent about what happens in financial markets nowadays, with derivative products adding to volatility when a surprise development comes along.

We saw that a month ago when the surprise wage rise data triggered a violent response from exotic ETF products linked to the highly speculative VIX, or fear index, in the US.

I hate it when I have to deal with uncertainty, though stock markets are always producing puzzling problems that you have to weigh up risk-wise. And the head-scratching issues around the bond market right now are a case in point.

Dealing in debt

One interesting plus pointed out by the Assistant Governor of the RBA, Christopher Kent, was the fact that corporate debt levels are not worryingly high, which means one potential market-crushing issue looks OK. Meanwhile he pointed to the position of our banks in this low interest rate and long-term lending/borrowing world that has emerged since the GFC.

Kent said our banks have wisely used this period of low interest rates and they have increased their average maturity of their debt from five years in 2015, to six years now.

DeBelle sees this as an action that “materially reduces roll-over risk”, which means we are not as exposed to rising global interest rates as were in the 1980s. In addition, a lot more of our foreign debt is written in Aussie dollars, which also reduces the impact of a global credit crunch that pushes up interest rates and lowers our dollar.

Sure any surprise worldwide spike in rates, and any related drop in stock prices would affect us, but we are in a better position today than we were in both the GFC and the 1980s.

This week’s Fed meeting features the new chair, Jerome Powell, and every word he says will be closely analysed. However it will be the reaction of the bond market I will be watching closely.

And then there’s another related scary thing and it involves China, which is the real target for President Trump’s tariffs play.

Bloomberg reports that: “China’s holdings of Treasuries fell to the lowest level since July as investors soured on U.S. fixed-income securities and the dollar at the start of the year.”

By the way, “China remains the largest foreign creditor to the U.S., followed by Japan, whose holdings rose for the first month since July, to $1.07 trillion from $1.06 trillion,” the news agency told us.

The fear is China might do a DeNiro “if you mess with me, I’m gonna mess with you” response and take its money home, which could easily force US interest rates higher.

That said, there should be a lot of potential lenders to the US Government with the economy doing well.

On Friday CNBC reported “consumer sentiment rose to a level not seen since 2004 in March, according to a preliminary reading from the University of Michigan.”

And keeping the good times rolling, the Labor Department said job openings increased to 6.3 million in January, a record!

I rationally worry about Trump, tariffs and the bond market, but the economic story in the US and in the rest of the world, including here in Australia, means that I’m betting and investing that stocks can crawl higher over 2018. But I damn well hope a trade war is averted. AMP’s Shane Oliver speculated: “Trump will use his Art of the Deal/go in hard approach to try and reach a settlement with China to which the Chinese are likely to be responsive to some degree as they know there is an issue.”

This helps me sleep at nights but I will keep one eye on that cursed, crazy bond market and when it really spooks me you will be the first I will tell! 

Peter Switzer is the founder and publisher of the Switzer Super Report, a newsletter and website that offers advice, information and education to help you grow your DIY super.

Content included in this article is not by association the view of FNArena (see our disclaimer).

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

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