Thursday, March 25, 2010

The end of an Era



It is my belief that we have reached the end of an era. Exactly when that ended (2000 or 2007) and to what degree is up for debate. However, what is evident is that we have reached the end of the era of low interest rates and easy credit that began in 1981. Likewise, if this turns out to be true, and interest rates have made a major bottom, that means U.S. Treasury bond prices have made a major top (since interest rates and bond prices are inversely correlated). The case for the end of the Bond bull market and the start of a major Bull market in interest rates can be made, I believe, from both a fundamental and technical perspective. From the fundamental perspective, the amount of outstanding U.S. Government debt issued is so large that it CANNOT be paid back and this type of fiscal situation is not sustainable in the long run, and I believe that eventually, the piper will be paid.In my view there is simply no way we can afford to pay back the debt when our GDP is 70% consumption. According to an official government website, treasurydirect.gov, the total public outstanding debt as of March 24, 2010 is $12,662,466,657,519.82. Bond Investors will demand a higher interest rate for the simple economic principle that risk requires compensation. If government debt is going to be considered high risk, you can bet high interest rates will come with it. In my opinion, it is only a matter of time before the Credit Worthiness of the U.S. government is put into question not just by foreigners (namely Japan and China) which fund a good portion of out debt, but by its own citizens. That is the fundamental part of the argument. From a technical perspective, above are two charts, both of the 10-year U.S. Treasury Bond yield. In Technical Analysis, we say that when downtrend lines are broken, they are retested, meaning the price of the security temporarily goes against the(new) trend to find support on the downtrend line in the case of a turn from a downtrend to an uptrend, and retest to find resistance at the uptrend line in the case of a turn from an uptrend to a downtrend. Granted, a break of the uptrend or downtrend lines are not guarantees that the trend has changed, but rather an indication of a possible trend change, hence the question mark next to the "retest after breakout" annotation on Chart 2. If the downtrend in interest rates is continuing, then the downtrend line will not act as support and the 10-year yield will break back below the downtrend line. However, if I am correct in my analysis and interest rates bottomed in 2008, the spike low in the Fall of 2008 was just a final thrust down in interest rates (and thrust up in bond prices) before making a major trend reversal. Chart 1 is the same as Chart 2 except that it is shown on Logarithmic Scale, while Chart 1 is shown in Arithmetic scale. Chart 1 illustrates the long term downtrend line on the 10-year Treasury yield. When that is broken, it will certainly be something to pay close attention to, because it will likely signal the start of a multi-decade move up in interest rates. In addition, on chart two I show a common indicator called the MACD, which stands for Moving Average Convergence Divergence. Without going into too much detail, this is an indicator of momentum. When price makes a lower low or higher high and the indicator does not confirm with a higher high or a lower low (depending on the trend), it is called a divergence. In this case price (Interest Rates) have made a lower low, but the MACD has made a higher low, creating positive divergence. This is another sign that the momentum in the long-term downtrend in interest rates is slowing dramatically and a turn higher is coming, possibly (likely in my opinion) as early as this year (2010). I will post an update if and when this happens. As a side note, rising interest rates are generally not positive for equity prices, and with the way things look now, if interest rates spike higher, it could be accompanied by a precipitous drop in equity prices and quite possibly a resumption of the bear market in U.S. equities. I will also post an update on the stock market soon.