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As a rule, the bond market is one of the most
sophisticated markets going, and one of the world's biggest. Within that
particular market, the bond traders are generally noted for their high IQ's
as well as for their thick skin. It's a tough business, and now that I think
about it, I've never met an "old" bond trader. Many years ago, I
went out to lunch with a group of floor traders in New York City and I commented on how
relaxed they all seemed. All accept one! He worked the bond pits, and in
spite of his somewhat elderly appearance, he was the youngest person at the
table. The bond market can also be quite fickle; just ask the Federal Reserve
Chairmen, past and present. They've raised rates for months but that didn't
always have the desired effect as the bond pit often went against the flow. Now
that the Fed is supposedly near the end of its tightening cycle, the bond
traders are raising rates like there's no tomorrow.
The Fed's magic number, if such a thing exists, was
estimated by many to be 4%. Well the magic number has come and gone, and it
now appears that bonds have fully priced in a 5% interest rate - and I really
don't see an end in sight. There are some very intelligent individuals like
Bill Gross (www.Pimco.com) and John Maudlin (www.2000wave.com) you feel that
the Fed will probably go too far in raising rates, and once they see the
error of their ways, will quickly reverse course and take rates lower. In
particular, Maudlin feels that rates will begin to decline before the end of
the year. I'm not so sure! Before I get into all my reasons for taking the
opposite side of the argument, I would like to take a look at the following
Weekly Chart of the US Treasury Bond:
 
You'll see that bond prices peaked in July of 2005
and have since made a series of lower highs and lower lows. In March of this
year, the bond price broke below the 200-w.m.a., and just last week broke
below the bottom band of a long term trend line that has held up since
January 2000. All in all, it's quite a bearish picture.
I prefer weekly and monthly charts because they tend
to filter out all the day-to-day garbage, but if you were to look at a Daily
Chart (go to www.stockcharts.com and punch in $USB), the picture would be
considerably more bearish. The first thing that would catch your attention is
the fact that we are extremely oversold. Also, the bottom band of the
downward sloping trend line was violated last week. Finally, you would see
that the 50-d.m.a. crossed below the 200-d.m.a., and bond prices are now
trading below both. That's quite bearish and gives a sell signal. As
oversold as we are, chances are we'll head lower.
So what is going on here and what are the
consequences, intended and otherwise, if bond prices head lower (and
inversely interest rates continue to rise)? What happens if I'm wrong? Before
we tackle these questions, you have to understand what an interest rate does.
Simply put, it is a reflection of risk. Higher rates mean higher risk and
vice versa. The United
States has historically enjoyed a low risk
status and that status was a reflection of the fact that we were the world's
largest creditor nation for decades. That changed some years back and we've
now become the largest debtor nation the world has ever known. I'm sure Mr.
Gross and Mr. Maudlin would both agree that the U.S. is not currently on a path
toward fiscal responsibility. Others, like Morgan Stanley's Steven Roach,
would probably go so far as to say that our current path could possibly lead
to our economic destruction. Presently, the United States requires a daily
injection of $2.7 billion of other peoples money in order to exist. Until
just recently, there hasn't been a lot of competition for other peoples money
as Asia, and Europe to a lesser degree,
pursued loose money policies. Japan
even went so far as to implement a negative interest rate for a period of
months, and that's about as loose as you can get without using a helicopter.
The Federal Reserve has now made fifteen consecutive
interest rate hikes and has given the appearance of a tight money policy. As
is often the case with the Fed, appearance can be deceiving! The tight money
policy of raising rates was more than offset by the loose money policy of
printing dollars until the cows come home. Now that the Fed is no longer
obliged to publish the M-3 statistics, you can rest assured that the printing
press crew will be receiving time and a half for overtime. How can I be so
sure? It's really quite simple: gold is telling me that almost on a daily
basis. Gold is the only real money out there and it is taking more and more
fiat dollars to buy real money every day.
Given everything I've said, what would happen if the
Federal Reserve ends its so-called tight money policy and, God forbid, even
begins to lower rates? Since the rest of the world is now raising rates, and
smart investors are looking for the best return relative to risk, it stands
to reason that they'll buy Asian or European debt before they'll buy U.S. debt. Actually
that process began some months ago as Central Banks now account for less than
25% of all U.S.
bond purchases. Toss in the fact that the U.S. is currently pursuing a
reckless fiscal policy, and it's no contest. No one in their right mind would
want to loan money to a high risk client for a low return. I'm sorry Mr.
Gross, but rates may not be coming down as soon as you think.
Now let's take the other side of the argument and
look at what would happen if we continue to raise rates. Given the fact that
the U.S.
economy is slowing down, you'll push it into a recession, or worse yet a
depression. Increasing rates together with and out-of-control money supply is
a recipe for stagflation. Additionally, you will also break the backbone of
the economy, i.e., the housing market. Personally, I believe that process is
already underway. Take a look at the following Daily Chart of the
Philadelphia Housing Index ($HGX) and you'll see what I mean:
It is obvious that both RSI and MACD have turned
down while the stochastics are now negative, but what is really important is
this: the 50-d.m.a. has now crossed below the 200-d.m.a. and, as of Thursday,
we are trading below both. I believe that indicates that the top is now in
for the housing market, and by implication the U.S. economy as well as the stock
market. Furthermore, over the short run, I believe there will be more
downside to come as the RSI and MACD are still in neutral territory.
I do not believe it is a coincidence that the bonds
as well as the interest rate sensitive HGX have both broken down at the same
time. Another index sensitive to rate changes is the Dow Jones Utilities
Index ($UTIL), and if I were to post a Daily Chart, you would see a complete
break down; far worse than what you see in any chart above, and it began
months before the HGX breakdown. This is important because the major turns
in the Utilities Index often signal major turns in the economy as well as the
DJIA.
I want to take this discussion a bit further now. Real
wages for the U.S.
consumer have been stagnant now for some time and this is the same consumer
drowning in debt. The cost of that debt, if the bond market is any
indication, is now rising weekly. Prices are out of control - just look at
the CRB Index closing at a record high on Friday for an indication. Let's see
now: rising costs, rising prices, and no increase in salaries. At best, that
is the road to recession. Until recently, the U.S. consumer was able to bail
himself out by refinancing his house. I no longer see that as a viable
option. Defaults will increase (they already are), banks will suffer, and
things will become ugly. Americans actually have a negative savings rate, the
first time since the Depression, and are in no condition to tolerate even the
slightest financial impediment. I've learned the hard way that whenever you
find yourself in a weak position, unable to endure setbacks, the setback
invariably presents itself.
In conclusion, the Federal Reserve Chairman, Ben
Bernanke, has a real problem. If he continues to raise rates, he will drive
the country deep into recession and, given the massive debt load, even into
Depression. On the other hand, if he lowers rates, no one will buy his debt
and he'll have to print more and more fiat dollars. Eventually, he'll have to
drop the stuff from helicopters and hyperinflation will set in. If the truth
be told, it is different this time around. The Fed is out of tools and
Bernanke is like a matador about to be gored by the bull, it's just a
question of choosing which horn. Although I suspect he'll choose the
inflationary horn, the end result is the same, the death of the matador. Unfortunately,
the U.S.
economy and consumer will be dragged down with him. In the end, you'll see
the stock market, the dollar, and the bond market all down hard. Actually,
we've seen the beginnings of that process over the last couple of months. The
only shelter from the storm will be gold and silver.
Enrico Orlandini
Dow Theory Analysis
Ignacio Merino 636, Santa Cruz,
Miaflores, Peru
Phone: 001-51-56-973-5599 - Fax
: 001-51-19-280-8796
Email: ebo@dowtheoryanalysis.com
Website: www.dowtheoryanalysis.com
For those of you interested in receiving
information on the Funds we manage, please feel free to e-mail us at ebo@dowtheoryanalysis.com and we will respond as soon as possible.
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