Rising Rate Realities

The entire global economy now clings precariously to one crucial phenomenon. That is, how much longer can the central banks of the developed world artificially suppress interest rates at near zero percent?

The violently-negative market reaction to Janet Yellen's comments during her first press conference was a clear indication of how vulnerable the stock market is to the eventual reality of rising interest rates. All Ms. Yellen did was remind investors that the Fed Funds Rate would have to be moved up from zero percent—probably beginning in the middle of next year. That was enough to send the major averages cascading downward faster than you could say the words “flash trading.”

In typical fashion, a cacophony of Wall Street Cheerleaders were quick to dismiss the negative market reaction by claiming investors misunderstood what the new Chairperson meant to say; or that the rookie Fed Head simply misspoke. And, more importantly, these bubble-apologists also were quick to make the case that even once the Fed eventually gets around to raising interest rates, it will merely be a sign of economic health--a move that the equity market should fully embrace.

The reality is that rising interest rates will soon arrive, either courtesy of the Fed or through free market forces. And a rising cost of money never bodes well for the stock market or the economy. This fact will be especially true this time around because growth—or the lack thereof--won’t be the salient issue; but rather it will be the attempt to end the Fed’s massive manipulation of rates. The removal of the Fed’s all-encompassing and price-indifferent bid for Treasury debt will place tremendous upside pressure on rates. And even if interest rates do not increase, the outcome for investors will be equally devastating—I’ll explain the simple reason behind that in a minute.

But first let’s see if rising interest rates are really all that good for equities, as Wall Street so desperately wants investors to think.

The 10 Year Note is Spain was trading at the 4% level during October of 2010, while the benchmark IBEX 35 was trading at 10,900. Yields then surged to 7.7% by August of 2012. Not because the ECB raised interest rates, but because the free market deemed its sovereign debt to have come under significant duress. The IBEX tumbled 35% to 7,040 in less than two years.

It was much the same story In the United States. Interest rates went through a secular uptrend throughout the 70’s and into the early 80’s. This time it was an outbreak of inflation that caused yields to rise. In March of 1971 the Ten Year Treasury had a yield of 5.5%, while the S&P 500’s value was 100. By January 1982 the benchmark yield soared to 14.8% and the S&P 500 traded at just 115. During those 11 years the market increased by a total of only 15%, even though consumer price inflation skyrocketed 135%! This means in real terms investors in U.S. stocks lost over 50% of their purchasing power.

Staying in the U.S., rising rates in 1987 didn’t bode well for the market either. The Ten-Year Note started off in January at 7.01%, and jumped to 10.23% the month before the Dow crashed 22.6% on October 19th 1987.

It is true that there are brief periods when stocks rise at the onset of rising rates. However, the reasons why interest rates increase in a significant and protracted manner are because of rising inflation and/or burgeoning debt levels--and that is never healthy for equity values or economic growth.

What will happen to our debt-laden economy once interest rates normalize? Municipalities will come under great stress, as they try to manage soaring debt service payments from a tax base that is quickly eroding. Real estate flippers will be dumping their investment properties, as home prices begin to tumble once again. Equity market investors will sell shares, as the record amount of margin debt is forced to be liquidated. All forms of adjustable rate consumer debt will come under duress,   severely hampering discretionary consumption. Banks’ capital will be greatly eroded as their loans, MBS and Treasury holdings go underwater—vastly curtailing the amount of new credit available to the economy. The Fed will be deemed insolvent as its meager capital quickly vanishes. Interest payments on Federal debt will soar, causing annual deficits to skyrocket as a percentage of the economy. And, the over $100 trillion market for interest rate derivatives will go bust. This will be the result of creating an economy that is completely addicted to debt, asset bubbles, ZIRP and QE for 7 years.

In essence, the entire economy will collapse…perhaps this is the real reason why the Fed found it expedient to completely remove the numerical unemployment rate target for when it would begin rising rates. Let’s be clear; the Fed is ending QE not because the economy has reached the inflation and unemployment goals it set out to achieve, but rather from fear of the monstrous size of the balance it has created.

But what if interest rates don’t rise as a result of the Fed’s exit from QE? If interest rates stay at these record-low levels it will be because the private market supplanted all of the Fed’s purchases at these ridiculously-low yields.  The only reason why that would occur is if the tremendous deflationary forces unleashed in the wake of the Fed’s absence from its support of money supply growth causes equity and real estate prices to tumble, bringing the economy along for the ride.

In either case the outcome for investors will be shocking. Market participants should prepare now for the failed exit of QE. On the other side of this imminent revelation will be unsurpassed volatility between inflationary and deflationary forces, which will dwarf those experienced during the credit crisis. Because of the unprecedented and unsustainable amount of debt outstanding, central banks now face only two choices: stop printing money and allow a devastating deflationary cycle to pop the asset bubbles that exist in equities and real estate; or continue expanding the money supply until hyperinflation eradicates the middle class and the economy.

Therefore, our Investment outlook remains very cautious. It should be noted that the S&P 500 is up just 2%, and we are in April. That paltry return is not worth the risk of being anywhere close to fully invested. In fact, I believe a trap lies in waiting for long-only investors. An anemic global economy, a record amount of margin debt and the Fed’s tapering of asset purchases will cause a sharp selloff very soon. To be specific sometime between now and before summer gets going. We will use that opportunity to get back into the market at much lower prices.

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Michael Pento is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

mpento@pentoport.com

twitter@michaelpento1

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