Why Interest Rates Will Rise in 2010

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.

While stocks were rallying, long-term U.S. treasuries were selling off sharply and interest rates climbing on December 21st. The rally was particularly noteable because 10-year bonds were selling down more strongly that 30-years - the opposite of the normal pattern. As part of its quantitative easing program, the U.S. Fed was purchasing 10-year treasuries up to October 31st of this year and this kept their yield artificially low. This trade now seems to be unwinding. Interest rates on consumer loans in the U.S., including mortgages and credit cards, are usually tied to the the 10-year treasury rate. Higher rates will dampen consumer spending going forward and this will be a negative for the economy in 2010. Investors can take advantage of rising rates though by buying ETFs that short longer-term bonds.

Long-term rates need to be examined in context. The yield spread, or the difference in interest rates, between them and short-dated paper provides significant information. The yield spread between 30-year treasuries and the 3-month t-bill has gotten to around 4.50%. This is much larger than normal. The spread was even bigger this June and in 1992. In the last two recessions in the early 1990s and 2000s, yield spreads didn't peak until about 18-months after the recession was over. They already got to those previous peak levels this June, during the recent recession. This indicates that the peak in the current cycle is going to be higher than it was previously. Assuming the current recession ended in July, as would be inferred from government GDP figures, this would indicate that there will be a peak in the yield spread around January 2011. Note that this is not the same as a peak in rates. The spread will narrow if long-term rates continue to go up, but short-term rates go up even faster.

While it looks like long-term rates are going to be higher in 2010, the exact amount is not predictable from yield spread analysis. From a technical perspective, the 10-year treasury will have a significant breakout if its yield rises above 4.00% and stays there. For the 30-year treasury, the key rate is 5.00%. Possible interest rate targets for the 10-year after a breakout are 4.75% to 5.50% and for the 30-year 6.00% to 7.00%. A breakout is not taking place just yet however. As of now, some time in the first couple of months of 2010 looks like the most likely time frame for this to occur. Investors who want to short 7 to 10 year treasuries can buy TBF (100% short), PST (200% short) or TYO (300% short). Investors who want to short 20 to 30 year treasuries can buy TBT (200% short) or TMV (300% short of 30-years only).

A wide yield spread between short and long term bonds is usually cited as an indication of strong future economic growth. Others say it is an indication of rising inflation expectations. Both views can be correct. The pattern is caused by central banks pumping substantial amounts of liquidity into the financial system. This shows up in the economy and inflation at different points in time. Liquidity first pushes up the stock market (we have already seen that), next impacts the economy, and then shows up as inflation. When there is overlap between the economic growth and inflation phases, stagflation results. It can take as much as three to four years for the first wave of inflation to peak. That would take us to at least 2012 in the current cycle - so we have a long interest rate rally ahead of us.

Disclosure: Long TBT and TMV.

NEXT: GDP Revisons Indicate Recession Isn't Over

Daryl Montgomery
Organizer,New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

Short Bonds When Retail Sales Improve

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.

U.S. November retail sales were released on December 11th. The mainstream media described the positive numbers as a 'surprise', which has been the operative word for a number of better than expected government reports lately. The reason they have been a surprise and better than expected is that evidence from non-government sources contradict them. Same store sales for major retailers in the month of November have been generally dismal. Yet U.S. government statisticians somehow found a 1.3% increase in overall retail sales. As I have said many times, the statistics are recovering, it's just the economy that's not doing well.

The November retail sales report is the first one issued using a 'revised' sample. The sample is changed every two and a half years. While reported sales improved after changing the sample (government changes frequently seem to produce better numbers), they were doing well in the preceding few months before the revision. Retail sales were up 1.1% last month and 2.4% in August. The August numbers were the result of the U.S. government's 'Cash for Clunkers' program, a free-money giveaway to U.S. consumers so they could buy cars. Interestingly, the October numbers were up because of auto sales as well, these supposedly increased by 7.1% - and this was after 'Cash for Clunkers' was long over. It is quite amazing the American consumers can keep buying cars and trucks despite high unemployment, an already huge debt load and reduced credit availability. Where does the money come from?

U.S. retail sales numbers are based on a mail survey to 5,000 retail establishments out of a total of as many as three million. The numbers are adjusted for seasonal variation and holiday and trading day differences. Amazingly, they are not adjusted for inflation. So reported retail sales can be higher if the number of sales are decreasing, but prices have gone up. They therefore can indicate more inflation, improved economic activity, or a combination of the two. The place to look to see if inflation is the impetus behind increasing retail sales numbers is gasoline sales. These are approximately steady in volume at this time of year, so a big rise indicates higher prices. And what item in the retails sales report had the largest rise? It was gasoline sales by far. As a further check, U.S. import price numbers for November can be examined. These were released the same day as the retail sales report and are a pure measure of inflation. They were up 1.7%, even more than the 1.3% increase in retail sales.

While the retail sales figures are somewhere between suspicious and a good confirmation of inflation, the market did not react that way. In the short-term traders believe any number published by the U.S. government, no matter how absurd. Gold had a sharp drop when the report came out, although it should have risen on the inflation implications. Stocks and the U.S. dollar went up, although inflation is a negative for them. Bonds sold off and interest rates rose. This is the one safe haven for investors on higher retail sales news, since interest rates will go up because of a better economy and because of inflation, so the reason for the higher retail sales numbers is not important. The long-end of the yield curve will move the most. There are a number of ETFs that the average investor can use to short bonds (or go long on interest rates since interest rates move up when the price of bonds go down), such as SHV, PST, TBT and TMV (listed from least to most aggressive). Interest rates are starting to move up so it looks like shorting bonds is are a win/win trade.

Disclosure: Long gold, TBT, TMV

NEXT: Five Reasons That Gold is Going to Rise: A Response to Nouriel Roubini

Daryl Montgomery
Organizer,New York Investing meetup
http://investing.meetup.com/21


This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.