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Greg, if there was one number I should be watching, if I only have enough time to follow 1 market, what should that be? Answer: I’d say watch 10-Yr US Treasury Bonds! It is well documented that asset markets are underpinned by a mountain of debt. That debt has a cost, and that cost is impacted by the interest rate on 10yr money. Any increase in the cost of debt will have a domino effect on all capital markets. So what’s our old friend telling us now?
Chart 1 Hmmm Interesting! On the daily chart Bonds have recently broken down from a head & shoulders pattern (blue lines) implying that the price will weaken further (interest rates, the inverse of price, will rise). The target of this pattern is 105.5. A sustained move below 106.5 brings into play a larger technical formation with a downside target of 104.0 (green lines). [the MACD and RSI look oversold so short-term we may see a 1 -2 month technical bounce in Bonds]. A rise in interest rates is consistent with the monthly chart I presented in my article Merger Mania. Monthly 10yr Bonds have bounced off parallel and lateral resistance. Long-term channel support comes in at around 5.5% (currently 4.77%) which is quite far off. Overall, probabilities favor lower Bond prices and higher Bond yields for a good portion of 2007. Knock On effect - Real Estate and Stocks The 100 Pound Gorilla in the debt market is Mortgage paper. Most mortgages are priced off the 10-Yr Treasury note. Therefore, it would be fair to assume that Real Estate should be highly correlated with 10-yr bonds. And, as the next chart shows, it is a major determinant:
Chart 2 The correlation is clearly visible. As interest rates moved lower in 2006 (bond prices higher – bottom of chart blue lines) Homebuilding stocks (blue lines) pulled out of their declines. If we are entering into a period of higher interest rates (green arrows), the real estate market will have some further pain ahead of it. It is now well documented that the US is a Consumer economy. Consumption is the major economic activity in the USA. Consumers are the engine of growth and have remained strong by extracting equity from their appreciating homes. A prolonged slowdown in housing will eventually slow down consumption, economic growth and corporate earnings. Stock Market and Gold Stocks When the stock market begins discounting the enormous drag on earnings we’ll probably see a Major long overdue correction. On cue Gold will rally above its 2006 highs on the expectation that the next round of Fed Induced Money Supply growth must begin. DOUBLE WHAMMY FOR GOLD A significant difference between the next round of Money Printing and the reflation of 2002 (the previous Bear Market in Stocks) is that Long Term Interest Rates will be rising. That is, it will be hard to disguise the fact that inflation is running wild even whilst Asset Prices are dropping. The Fed will have to Print an exorbitant amount of money to achieve the same economic boost as in 2003 whilst somehow preventing a hyperinflationary breakout. Under such a backdrop, the current Gold price is nothing short of a steal!
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