by Lance Roberts
The great "bond bull market" is dead.
Interest rates are rising on expectations of stronger economic growth ahead.
The "great rotation" from bonds to stocks is afoot.
These are all statements I have heard being made over the last month as 10-year interest rates went on a surge from deeply oversold levels to grossly overbought levels during that time span. The question, of course, is whether the stock market continue in its current bull market trajectory in the face of higher interest rates? Today's chart of the day is an overlay of the 10-year treasury rate and the S&P 500.
I have noted several things of importance in the chart above:
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The vertical dashed lines denote when rising interest rates either led to a correction in asset prices or an economic recession.
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I have noted major events for a chronological perspective.
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The secular bull market of the 80-90's was spurred by falling interest rates and inflationary pressures which boosted corporate profitability. With the markets valued at roughly 7x earnings with a near 6% dividend yield the markets were primed for credit expansion fueled stock market boom.
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I have noted (red circle) the recent "surge" in interest rates for some perspective. While the recent rise has certainly gotten the markets attention as of late; from a historical perspective we are still well within the confines of the current long term downtrend.
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I have also noted the similarity between the secular bull market in the 60-70's versus 2000 to present. The breakout to "all time" highs is not necessarily an indication of the beginning of new "secular bull market". With valuations currently 19x earnings on an trailing reported basis, earnings growth peaking for the current economic cycle and sub-par economic growth rates; the fundamental backdrop for a continued bull market from current levels is not available.
The "bull case" for the continued run in equities has been built around the continuation of monetary interventions from the Federal Reserve and a near zero-interest rate policy. However, if interest rates begin do begin to rise in earnest the fundamental backdrop changes dramatically:
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People buy "payments" rather than houses. Therefore, the much vaulted support from the sub-3% contribution from housing to the economy will dissipate rapidly as demand slows and prices fall to find buyers.
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Mortgage refinancing activity will slow to a stop. (Who refinances to higher mortgage payments)
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Higher interest rates make speculative home buying much less attractive.
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Personal consumption expenditures (which make up nearly 70% of GDP) will be negatively impacted as the rising costs of variable rate credit lowers discretionary incomes.
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Corporate earnings will decline as higher borrowing costs impact profitability.
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Corporate capital expenditures will slow as higher borrowing costs reduce the attractiveness of returns on new projects.
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Markets will be negatively impacted as higher leverage costs reduce profitability.
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Corporate bond issuance will slow sharply as borrowing costs surge.
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"Junk Bonds" will come under duress as higher interest rates sap funding for troubled companies leading to defaults and bankruptcies.
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Highly indebted municipalities are likely to be "shut out" of the municipal bond markets to obtain funding leading to defaults (i.e. Detroit)
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Higher interest rates will blow a massive hole in the CBO's government budget and deficit forecasts.
The list goes on but you get the idea. The impact of substantially higher interest rates are not good for the economy or the financial markets going forward. In the short term consumers, and the financial markets, can withstand small incremental shifts higher in interest rates. There is clear evidence historically to suggest the same. However, sustained higher, and rising, interest rates are another matter entirely.
However, before you get to excited, look back at that red circle in the lower right corner of the chart above. It is important to keep in perspective the recent "surge" in interest rates that has gotten the market's attention as of late. In reality, this is nothing more than a bounce in a very sustained downtrend. Is the bond "bull market" extremely long in the tooth? You bet. Does that mean that interest rates are set to surge higher in the near future? No.
While there is not a tremendous amount of downside left for interest rates to go currently - it also doesn't mean that they are going to substantially rise anytime soon. Weak economic growth, an aging demographic, rising governmental debt burdens and continued deflationary pressures can keep interest rates suppressed for a very long time. Just ask Japan.
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