When I listen to commentary about the markets, one of the biggest concerns I hear is that higher rates will derail the economic recovery. Housing will top. The gravy train for financials (refinancing loans) will lose steam. That’s one side of the interest rate coin, but of course a coin has two sides.
We are at record low interest rate levels. It is inevitable that rates will eventually go up, as they have in the past. The last time that happened was after WW2: interest rates began a 30-year climb. Were analysts pounding the table in the 50's that the economy was going to collapse in a rising interest rate environment? Did housing peak then? Did stocks peak as interest rates began to rise? No, they did not.
The yield on a 10-year Treasury Note has completed a bottom pattern. This happened when the yield climbed above 2.4% in June. The initial shock upset the markets based on how fast it moved and on the surprise comments from Bernanke’s press conference that the taper would complete and QE3 would end roughly by mid-2014—if everything went according to plan. He has since retreated from these comments to specify that QE will be data-dependent—which was the original plan back in September of last year.
Technically speaking, the six-year downtrend in the 10-year yield is still intact, even though we have had a substantial rally this year. That is to say that while the long-term trend (26-52 weeks) has reversed as of this year, the secular trend (25 years or more) has not. Imagine a WW2 battleship traveling at 30 knots trying to do a 180-degree turn. Like a battleship traveling at 30 knots, it will take time for interest rates to reverse a 30-year downtrend.
Economics = Marketomics
Rates have been moving up along with stock prices because rates aren’t just going up on taper talk, but on better economic news. Take a look at the 10-year Treasury yield over the past few months and note the turn in May when the April jobs report came out with better than expected results. Today, was the best reading in the ISM Purchasing Managers’ Index (PMI) since 2011 at 55.4. This was also the biggest one-month increase since 1996. The components of the survey were positive with orders, production, and employment jumping. The improvement suggests that manufacturing will contribute more to growth this quarter than analysts originally anticipated, thus lifting stocks.
Jobless claims dropped to 326,000 at the end of last week. This is the lowest figure since January 2008. Combined with the ADP private payrolls from yesterday, and analysts are bumping up their expectations for tomorrow’s Bureau of Labor Statistics data.
China’s PMI for its large enterprises came in better than expected at 51.6 compared to 48.8 for mid-sized enterprises and 49.5 for small-enterprises. Note anything below 50 is a contraction while anything above 50 is an expansion from the last reading. Chinese stocks (Shanghai Composite) rose on the data, up 1.77%. Chinese stocks are near last year’s support level. China’s economy has been decelerating (albeit still growing) for some time, but the PMIs were encouraging that stability might be near.
Europe’s PMI data for July suggests the same thing. The PMIs have been recovering from the low 40's and came in at 50.3 versus an estimate for 50.1. One key component that deserves note is that both Italy and Spain moved back above the key 50 threshold.
The S&P 500 broke to new highs on May 3rd when the jobs data turned around. Today, stocks and rates moved higher based on stronger economic data. These are positive catalysts and the market responded in kind.
Conclusion
This isn’t the 70s. I believe rates, even if they move up to 4% on the 10-year Treasury note wouldn’t adversely affect the economy. Companies continue to report that conditions are stabilizing in Europe, now we just need Asia and the rest of the world to stabilize and we could have stock markets around the globe moving higher, once more. The other side of the interest rate coin, is that higher rates will encourage investors to sell their bond funds and individual bonds (if they can’t wait until maturity) and buy stocks for income purposes. There was a big exodus from bond funds in June. According to ICI research, bond funds saw .47 billion leave, while stock funds only saw an outflow of million. A month later and the S&P 500 is 8.5% higher. Hmm... I wonder if higher rates have caused funds to pour into equities? Recent data from ICI looks encouraging.
