A few columns ago I suggested that investors would be better served by moving out of Treasury bonds, CDs and money markets into higher yielding instruments. My motivation for that advice was two fold: the Federal Reserve had cut rates as far as it thought reasonable and my conviction that inflation was moving higher. That proved to be the correct call. Today I am sounding a warning that the price of 30 year Treasury bonds (called the Long Bond) are poised to move lower. It will be the first of many moves as interest rates climb higher.
But wait a minute, you say, isn’t the economy in recession? Didn’t the Federal Reserve just finish cutting rates over the last 12 months to stimulate the economy? Yes to both questions but it isn’t the Fed or the recession that bond holders are most worried about. Inflation, the nemesis of the bond market, is the cause of their concern.
Inflation eats away at a bond holder’s rate of return and as investor’s perception of inflation increases so does their demand for higher real rates of return. So how does that impact the stock market? A little back up in rates won’t really kill enthusiasm for stocks but as inflation increases and the economy recovers, rates could go even higher and that could spell trouble.
Right now, everyone is focused on inflation thanks largely to the high prices of energy and food. There are even some people arguing that the Fed should begin increasing rates right now before inflation gets any worse. Personally, I don’t think Ben Bernanke and his merry men would do that before the presidential elections. It would just not be the politically correct move to make, besides, the bond market is perfectly capable of jacking rates up on its own.
Clearly higher rates would offer support to our currency. We have actually seen the dollar begin to stabilize and even strengthen since the last rate cut. A higher greenback would dampen the impact of commodity prices as well since most commodities are priced in dollars. So on the margin a bump up in interest rates could actually be good for stocks. But at some point other areas of the economy begin to be impacted. Higher rates on the 30 year bond would definitely put a hurting on the mortgage markets and therefore housing. Higher rates would also slow economic growth. How much higher would rates need to go before severely impacting an already weak economy? That, my dear reader, could be the trillion dollar question.
But hey, none of that is really important right now. Oil prices dropped this week and are now trading in the $125/bbl range. As predicted, the stock market rallied on that news and the S&P 500, after breaking support last Friday, is now back above the 1400 level. May marks two straight months of up markets this year, why, some folks could even call that a trend. Me, I’ll stick with my trading range right now. Expect the dollar to move up, interest rates to do the same, commodities to back and fill and stocks to move cautiously upward toward 1430 on the S&P 500.