Bonds Taking a Beating, Interest Rates Set to Rise

Includes: DBC, JNK, TBT, TLT, TMV
by: The Intermarket Edge

There are very strong indications as of late that point toward imminent rate hikes in both the eurozone and the U.S. Lately a few of the Federal Reserve members are curious as to why their calculations do not show strong inflation, and yet in every aspect of inflation measurement that the market puts forth inflation is already hitting:

  1. Are commodities rising?
  2. Is gold rising?
  3. Are industrial metals rising?
  4. Is the CPI rising?
  5. Are interest rates rising?

Once again, these are some important questions and classic measurements of inflation and inflation expectations. To say "this time is different" is to ignore the past trends, deny the present trends and consequently underestimate inflation. I may be making bold claims and these ideas may seem crazy until they play out. However I believe there are limited options left for the U.S. in terms of its fiscal health. It can choose from a few things in the near future:

  • Defaulting on the massive debts.
  • Add another round of quantitative easing until the Federal Reserve bank goes bankrupt (after all, Peoples Bank of China has more U.S. dollars than the U.S. Federal Reserve bank itself).
  • Consequently, cause runaway or hyperinflation to reduce the debt and interest owed.
  • Hike the interest rate substantially.
  • Some hybrid of all the above.

Anyway you slice it, however, the massive liquidity injections have repercussions. The Keynesian school of thought has led to a massive build up of the debt. Simplified, it is also an indirect reflection of the "efficient market" theory. If the idea is to print money and accumulate more debt in bad times and pay it off in good times, that obviously is not happening in the U.S. I still watch "U.S. debt" to see how rapidly the debt and its' interest are rising.

How do we come to grips on what is happening in the real world? Is there a "process" that can give you an edge to take advantage of opportunities when any inflationary or rising interest rate scenario plays out? I believe there is.

  1. Get in touch with what the market is demonstrating in terms of its appetite for risk. Gauge the trends in inflation protected securities to see if the market agrees that runaway inflation and interest rate hikes are a possibility. Build up a wide consensus of trends.
  2. Look for relative strength of inflation protected securities against non protected securities.
  3. Look for confirmation of trends in industrial metals and the Baltic Dry Index/Handysize (as a proxy for U.S. exports confirming dollar weakness).
  4. Currency and commodities have inverse relationships. Are commodities rising in multiple currencies (indicating the inclination to dump paper in favor of hard assets and raw materials)?

Lets briefly explore what's happening as of late:

When we pop up a chart of "Junk" bonds in relation to Investment grade AAA rated bonds, the Junk bonds are clearly outperforming.

Click to enlarge charts

Inflation protected securities are not doing too bad at all when compared with the 10 year and the 30 year U.S. treasury Bonds:

The emerging market debt and bond markets outside of the U.S. are also outperforming to a great degree and it's definitely worth taking notice of these trends and what the implications are for fixed income.

At this stage it is no mystery that commodities are on the rise as well as economies attempt to slowly get rid of their massive U.S. dollar reserves (only one reason for rise in commodities).

Commodities continue to climb ever higher in multiple currencies. As these commodities continue rising interest rates are put under more and more pressure to rise. Junk rated bonds continue to rise along with the strength of emerging currencies that also benefit from a rapid rise in commodity prices. What does this suggest for interest rates? Well, I try not to make wild assumptions. I believe they are headed much higher and a lot faster than some people may believe is plausible.

Ask yourself whether it is possible to have a bear market in U.S. bonds after the budget is addressed?
Click to enlarge

If you believe there is a possibility of an interest rate hike, then U.S. long term bonds are going to get pummelled. Frankly they don't look very healthy now anyway. The only legs TLT has left are the prosthetic ones created by the Federal reserve.

Until the intermarket forces suggest otherwise, I am long TMV.

Disclosure: I am long TMV.