Fears Of A Sudden Sharp Rise In Interest Rates Are Overblown

Includes: DIA, QQQ, SPY, TLT
by: Armchair Quarterback


When considering all of the factors that could derail the bull market in US equities, a sharp rise in interest rates is prime among them.

A review of historical velocity of money, interest rates and economic growth confirms that traditional monetary policy has become ineffective and has been replaced with non-traditional measures.

The US economy is growing and excess slack has been reduced but not to the extent that traditional monetary policy will be reinstated.

We do not expect a sharp rise in rates and therefore do not expect rates to pose a threat to the current bull market in US equities.

Geo-political events, earnings season, FOMC meeting, monthly employment report, Argentine debt default and a volatile stock market - all raised concerns about the sustainability of the current bull market in US equities.

With all of the things in the world to worry about, how much should we worry about a sudden sharp increase in UST yields?

Short answer is not much and here is why.

1 - Historical relationship between M2 money supply velocity, economic expansion and recession and the 10 year CMT rate:

The red line above shows the multi-decade bull market in US treasury bonds with yields on the constant maturity ten year note falling from a high in the mid teens in early 1980s to well below 3% currently.

M2 velocity was very high during the economic expansions of the 1990's and 2000's, increasing during the beginning of the expansion, peaking near the middle of the expansion and beginning a descent going into a recession.

M2 velocity fell drastically during every recession since 1980. Consumers and businesses pulled back and economic activity slowed down.

In the current expansion, we do not see M2 velocity rising which is quite different than previous cycles.

2 - So, if velocity of money is not increasing now, what is driving the economy forward?

This should be a relatively obvious graph but it's nice to see the picture. The blue line is the Fed's balance sheet and shows the sharp rise during the crisis to stabilize the situation and the gradual increase since then due to the numerous QE and asset purchase programs.

The red line is the Fed funds rate plummeting during the crisis and remaining near zero ever since.

Traditional monetary policy has been "tapped out" and the Fed has employed balance sheet expansion to generate economic growth and maintain some momentum.

3 - Transmission mechanism is working to some extent - excess slack in the economy is starting to work itself out

The two graphs above look the same but are slightly different. One plots the number of unemployed people in blue versus the capacity utilization in red. The other plots the unemployment rate in blue versus the industrial production index in red. Both graphs show that the slack in the labor force is reducing while production and capacity utilization are improving and reaching pre-crisis levels.

4 - Even with an improving economy, M2 Velocity shows no signs of increasing. This shows that traditional relationships between monetary measures and economic growth are still broken.

Above, we've shown another graph of M2 Velocity plotted against 10 year CMT for a shorter time horizon. The 10 year CMT yields have been choppy but the clear trend downward is still noticeable. The obvious question is when and how does this trend reverse.

Our premise is that as long as M2 velocity remains subdued, especially now that we are more than four years into an economic expansion, we doubt that there will be pressure on rates to rise.

In figure 2 above, we saw that the economy is not reacting to traditional interest rate levers.

Factors preventing short term rates to influence economic conditions, and M2 velocity to increase with economic expansion, include a glut of liquidity, tepid consumer demand and household balance sheet repair.

With all there is to worry about in the world, we do not believe a sharp rise in treasury rates is one of them.

Until economic expansion and capacity utilization reach a point that they affect short term interest rates and the velocity of money, we are not concerned about long term rates or a sharp fall in the US equity market.

We are watching geo-political events carefully but barring any major event, believe that the bull market in US equities has a long way to go.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.