Rising Rates not a Given
(March 27, 2005)
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The higher-than-expected CPI reading last week did not surprise us (although it did surprise quite a number of investors, apparently) considering the recent performance of the PPI – and considering the fact that some companies are now able to pass their costs onto their customers. In light of the CPI report, various publications are now calling for higher long-term interest rates – a call that has been very popular to make over the last few years (and a bet which one major Wall Street firm has lost a significant of money in).
The question to ask is: Is an increase of long-term rates a given, especially given the prospects of higher inflation (as measured by the CPI) going forward? According to this Bloomberg article, foreigners now hold $1.96 trillion of the total $4 trillion of U.S. Treasuries outstanding. The “kindness” of foreigners notwithstanding, it is obvious that the market for U.S. Treasuries is now a fictitious market and has been a fictitious market since at least the 1997 Asian Crisis – as most Asian countries have been adopting a “beggar thy neighbor” policy in order to export their way out of the economic doldrums. Japan has been a prime example. Quote from the Bloomberg article: ‘Until a year ago, Japan bought Treasuries with proceeds from yen sales it undertook to hold down the value of its currency as a way of helping its exporters. Japan hasn't sold yen since exchanging $290 billion worth of its currency for dollars in the first three months of 2004 …[On the other hand,] China buys dollars to ensure its currency, the yuan, stays at about 8.3 to the dollar, where it has been fixed for nine years. China's net purchases rose $700 million, its smallest jump since a net sale in February last year.”
For the foreseeable future, foreign countries such as Japan and China have no interest in dumping U.S. Treasuries – as they continue their mercantilist policy to suppress the value of their respective currencies. As a matter of fact, the United Kingdom has been a huge purchaser of U.S. Treasuries during 2004. From January 2004 to January 2005, the United Kingdom’s holdings of U.S. Treasuries increased from $91.8 billion to $163 billion – an increase of over 77%! The combined actions of the U.S. dollar and the Central Banks around the world over the last few years further convinces me that these holdings will increase further as the U.S. dollar continues to decline. Unless the Asian consumer markets can develop at an exponential rate over the next five years (in which case a higher Chinese Renminbi will not matter to the Chinese producers/exporters), this continues to be the high probability scenario.
Given that the market for Treasuries is more or less a fictitious market and thus is not really a reflection of inflationary expectations, the yield of the 30-year Treasuries, for example, is now solely dependent on the actions of foreign governments, hedge funds, and institutional investors. Given the recent CPI report, however, it is now natural to be bearish on bonds. As Mr. Mark Hulbert of Marketwatch.com says in his March 23rd “The lonely contrarian” article, however, this trade is just too easy. I will now quote the relevant paragraphs from that article:
As of Tuesday night's close, the HBNSI stood at negative 56.8 percent. The negative reading means that the average bond timer in this index is short the bond market. In fact, the current level equals this index's all-time low. Never in the years of our tracking this group of bond timing newsletters have they been more bearish than they are now.
In contrast, the gold timers are extremely bullish: As of Tuesday night, the HGNSI stood at 71.4 percent. That's within shouting distance of this index's all-time high reading of 89.6 percent.
From the point of view of contrarian analysis, these readings suggest that bonds are more likely to go up than down over the short term -- and that gold will do the opposite.
Over the past four years, for example, the HBNSI has dropped to this low a level just five times. Within the weeks following each of those occasions, the bond market staged a significant rally.
The most recent occasion on which the HBNSI was this low was last May 14, nearly a year ago. Over the subsequent four months, the government's 30-year Treasury bond rose by 10 percent.
Mr. Hulbert then goes on to hedge himself, however, as he states that sentiment isn’t the only thing when it comes to forecasting future prices. I agree with Mark on this one – but the extremely bearish reading on the HBNSI definitely says a lot and is a huge warning to bond bears. The bearish sentiment in bonds is further confirmed by the relatively low level of assets in the Rydex Government Bond Fund – a level that has not been this low since December of last year. Following is the relevant chart courtesy of Decisionpoint.com:
Again, please note that the last time the level of assets in the Rydex Government Bond fund was this low was during the early part of December 2004 – when the yield on the 30-year Treasuries briefly touched a level that was slightly north of 5%. From early December to early February of this year, the yield on the 30-year Treasuries dropped nearly 70 basis points. Combined with the readings from the HBNSI, it is now safe to say that the general sentiment of bonds is now very bearish, and given my thesis that the action of the U.S. Treasury market is really not a reflection of inflationary expectations, it is probably safe to say that the line of least resistance for bonds is now upwards (thus, lower yields), and not downwards as most people now expect.
Furthermore, the latest data (end of January 2005) that we have for U.S. Treasuries suggest that the Caribbean Banking Centers (a.k.a. the hedge funds) increased their U.S. Treasury holdings by a huge $23 billion during the month of January – an increase not seen since June 2004. Please note that the last time we saw such a huge increase, the yield of the 30-year Treasuries ultimately declined significantly in the next six months. Following is a monthly chart of the holdings of U.S. Treasuries by Caribbean Banking Centers vs. the yield of the 30-year Treasuries from January 2004 to March 2005 (note that the most up-to-date information on Treasuries only goes to January 2005 so far):
I am not inclined to give out any yield targets here but I would not be surprised if yields hit another 52-week low. In fact, this will coincide with our “flight to quality” scenario (thus, driving yields down) which we have been discussing for the last few weeks as capital flees from emerging markets back to U.S. assets/Treasuries – an event which I anticipate will happen in the next six to nine months. Bond bears beware: You know the “stock market blow off” that I have been expecting before this cyclical bull market can be declared over? Well, it looks like that we are going to have one giant “blow off” in the bond market before the stock market – a “blow off” that will kill many bond bears before this is over. Only until after this “blow off” will it be prudent to beat on higher yields going forward.
Let’s now go ahead and discuss the action of the stock market. First of all, since the last time we provided an update Thursday morning, there has only been one day of stock market action. Obviously, one day of action does not change my views. Considering the stock market was so oversold (per some of my technical indicators but not all) and considering that GE raised its first-quarter guidance and that Yahoo announced a $3 billion buy-back on Thursday morning , it is definitely disappointing to see a reversal in the major indices during late Thursday afternoon. However, this week will be a new ball game. The companies to watch out for in this upcoming week continue to be AIG, FNM, GM, and maybe even WMT. General economic news or reports include the Consumer Confidence number on Tuesday morning along with the jobs report on Friday morning. Overall, there aren’t too many new things to add – I still believe there “should” be a significant bounce this week but over the intermediate term, the line of least resistance for the stock market is still down.
Readers should note that I have already updated Bulls-Bears% Differential in the Investors Intelligence Survey on Thursday morning. Please refer to the Thursday commentary for my take on that latest reading. Since the results of the American Association of Individual Investors did not get updated prior to the completion of our commentary, I will now provide an update. Following is the weekly chart of the Bulls-Bears% Differential in the AAII Survey vs. the DJIA:
The weekly Bulls-Bears% Differential in the AAII is now at its most oversold level in over two years. The probability of a hard bounce during this upcoming week is now pretty high, but over the more intermediate term, the line of least resistance is still down.
Speaking of an oversold situation, the latest short interest data for the NYSE and the NASDAQ were also released recently. It is interesting to note that both the short interest on the NYSE and on the NASDAQ made all-time highs:
Like I mentioned in the above charts, short interest on the NYSE is now at an all-time high – a high that was previously surpassed during October 2002 – right at the bottom of the last cyclical bear market. Meanwhile, short interest on the NASDAQ has continued to increase since the bottom in October 2002. Bulls and bears alike should be careful here. While the market is definitely oversold per the short interest readings (in a bull market, short interest acts as “fuel” for a sustainable rally in stocks), it is definitely important to note that short interest had continued to make high after high even as the major indices embarked on their fateful declines during the 2000 to 2002 period. Short interest also made an all-time high in April 1930 and February 1966 – right before the bear market onslaughts that unfolded over the subsequent few years.
Bottom line: It looks increasingly certain that the long bond should continue to rally here (thus, driving yields down) – with the possibility of a final “blow off” top in bond prices during the next six to nine months. Bond bears beware. At the same time, my outlook for the stock market does not change from Thursday morning. We are now in an increasingly ST oversold situation – with the likelihood of a hard bounce increasingly likely. Whether that upcoming bounce is tradable or not I do not know (and will not try), but it is now late in the cycle and the line of least resistance over the intermediate term is definitely still pointing down.
Henry K. To, CFA