Thursday, October 15, 2009

Bond Market Bubble Update…

Remember this article and how prescient it was?

Bond Market Hide & Seek – A Domed House & 3 Peaks...

In that article, written in January of this year, I pointed out that interest rates had reached the end of the era of leverage when they hit ZERO:

Ten months later, rates are still at zero. The Federal Funds Rate really has only one direction left – up. That’s going to happen, just a matter of time. Just remember that the PRICE of bonds goes DOWN as interest rates go up.

So, I pointed out the Three Peaks and a Domed House pattern that was playing out in the long bond, and using TLT as a proxy labeled the points accordingly…

There were very few believers in this pattern at the time and, in fact, there were open doubters who expressed their disbelief even though I clearly explained the parabolic nature of the curve and that all parabolic moves eventually collapse, usually returning AT LEAST to their base, the beginning of the parabolic rise.

And now that the collapse has happened, the question is now what? And I’ll get to that in a minute, but let’s first look at the current chart and see where we are… I can count this two different ways and am not sure which is correct:

That count has better symmetry than this count and would indicate that the parabolic collapse phase is completely over. The following chart is labeled differently and would indicate that the collapse will continue:

Which do I favor? Well, interest rates must go up and thus in the long term I’m favoring that TLT must come down much farther. When we zoom into a six month chart of TLT we see a clear channel upwards, but that an internal uptrend broke to the downside and we’re now making a run at the bottom of the channel again. That’s the point that needs to be watched. A breakdown below that channel bottom would produce a very nasty target, one that would double the move down from the top targeting the 65 area of TLT!!

What would be the result if that happens? For one thing even more money would RUN from bonds. The question then becomes, “where would that money go?” The money that doesn’t flee would vaporize, thus continuing the deflationary trend. The money that does flee could run into an already overvalued equity market, or it could flee overseas. It will go wherever it’s treated best – I doubt it’ll be used to build new factories and to hire our unemployed, it’s still cheaper to hire workers overseas and our government still encourages it. Think you’ll see wage inflation? Think again.

The flow of capital, indeed, corresponds to the relationship of bonds down, stocks up as presented in this 3 year chart of USB (U.S. 30 year Bond Fund) versus the SPX:

The correlation on this relatively short term chart is actually better than the correlation between the SPX and the Dollar. There is, however, a lag between the moves of the bond market and equities. While I don’t have a good longer term chart to correlate historical moves further back, I know that the trend is for stocks to be rising BOTH while interest rates are rising and also when they are falling, which is the opposite of what many amateurs (and even some professionals) believe. Some professionals will say that lower interest rates are good for stocks and they go up as rates go down! Well, modern history (the twentieth century) shows that they get it both ways as rates rose fell below 2% in 1930, they stayed less than 2% for 22 years until 1952! From 1932 on, stocks basically went up. As rates went down from 1980 on, stocks went up (when I say stocks, what I mean is the stock indices, not individual stocks themselves)! They did, however stagnate in the late 60's through the 70's up until rates peaked in 1980. That stagnation is refered to by Elliott Wave technitions as a wave 4, the decline during the Great Depression was wave 2... So, the lesson of the past 80 or so years is that as rates drop, stocks go up, as rates stay less than 2%, stocks go up, and when rates rise, stocks stagnate. What will rates do in the next two decades? Many say that rates will stay low, but I say the math of debt is unworkable regardless.

THERE HAS NEVER BEEN A TIME IN HISTORY WHERE THE ENTIRE COUNTRY AND EVERY SEGMENT IN IT WAS DEBT SATURATED LIKE IT IS NOW, to include the 1920’s prior to the Great Depression. And that makes this time different than any other in modern history, doesn’t it? Now, you may have alarm bells ringing in your head because you KNOW that when people talk about “this time being different” that you appropriately run for the hills! All I will say is that before you discount that this time is indeed different, take another look at the chart of interest rates… from a peak in 1980 of 20%, all the way to zero, now nearly 30 years later. Then take a look at the debt curves – Personal debt, corporate debt, and governmental debt at all levels - never been here before, period.

So, as the direction changes, you could go back and say that rising interest rates get that way because the Fed is attempting to cool off an overheating market. And you would be wrong. The Fed mostly follows the market except in rare instances. So, I am going to posit that at some point rates are going to rise but it WILL BE DIFFERENT because of the PARABOLIC DEBT CURVES. This time when rates rise, it will dramatically increase the carrying cost of debt like never before. That will cause the correlation of rates up, stocks up to break down. Once again, this is based on more than a feeling, it’s based on the math of debt…

Boston- More Than A Feeling: