In my last article on August 14, I recommended taking a position in TBT (Ultra Short Long Bonds). Now the world is waking up to the possibility that long term interest rates may have bottomed and reversed. TBT reflects this change as it broke through its 200-day moving average and gaped higher.
The reason for the reversal is three-fold. First, inflationary expectations have reversed. We've gone from fears of deflation here and around the world to concerns of inflation in the future. Second, growth rates were approaching zero a year ago and recession fears here and abroad were rampant. We are presently running around 2% growth rates according to various tracking models. And third, the purchase of bonds has exhausted itself. Almost everyone - most hedge funds, institutions, and investors ran to bonds for yield and safety. When everyone is on one side of a trade the trade is over.
It's difficult to acknowledge a trend reversal that has been in place for thirty-five years, but that's what I told my subscribers of Market Update at Paulnathan.biz when discussing interest rates. Short term we will likely see a notable move higher. That's what I think we're seeing now in its infancy. But the case for higher interest rates is really the long term case.
It is inflation and debt that will be the movers of interest rates in the years to come. The national debt has doubled in the last eight years and the tendency in 2017, will be to spend much more money. Infrastructure and defense spending will likely lead the way.
As spending increases, deficits and debt will increase and inflationary concerns will rise with prices. The demand for materials and resources should raise prices in general, more than we've seen since 2014. But the real threat will be a potential inability to service the debt that we are determined to run up.
No one knows where or when that line will be crossed, but at some point the bond market will begin to fear a default on debt or some political variation of a default. Donald Trump alluded to it when he said casually that "debt holders might have to take a haircut". He has since disavowed any notion of a default, but what will the government do if the national debt increases to twenty-five trillion dollars over the next five or ten years and rates rise as they did in the 1970's?
Meanwhile, the dollar will come under attack as a simultaneous concern over a potential default and the use of the "inflation card" to extinguish debt, will lead to greater inflationary fears. The unfunded liabilities that must be paid for, will be the greatest motive to create money out of thin air to pay for services.
Real interest rates always outpace inflation in the long run, and so does gold. For this reason my long term investments are divided between resource stocks and TBT, with a bit of physical gold and silver coins for ultimate safety.
A lot of people believe that the Fed can control interest rates. The fact is they can only control the short end of the yield curve. The market is in control of most interest rates throughout the world. While it's true that a central bank can influence long rates, they cannot control them. The market in debt instruments is so large it makes puny the influence of central banks. The Fed knows this -- politicians do not, but they will learn this lesson soon.
The lesson was learned once in the 1970s when the Fed monetized the debt created by government to pay for the Viet Nam War and all the welfare programs legislated over the years. Inflation crawled, ran, then galloped during those years. At the beginning of the decade it was in the 2% range; by the end of the decade it had soared to 14%, the dollar was crashing, and interest rates leaped to 21%!
Can you imagine what would happen to the US government's ability to service the national debt if interest rates moved anywhere near that kind of level? The word "Venezuela" comes to mind.
So, the importance of making the entitlement system solvent is essential. And the importance of cutting government spending and reducing our deficits to enable us to service it, is essential. And preserving the value of our dollar and preventing inflation and higher interest rates from running out of control is essential. And yet, nothing is on the agenda of any politician to do anything of the kind. In fact benign neglect is on the agenda for most politicians as it has been for years and many more are in favor of greater government spending, i.e. fiscal stimulus.
This is why interest rates are beginning to rise.
Neither political party has shown any interest in entitlement reform or balancing the budget. On the contrary, both parties are more interested in increasing infrastructure spending, social spending, and defense spending. Only a handful of fiscal conservatives remain in office, and they are branded as "the establishment" and ignored in favor of helping this or that constituency.
So expect interest rates to rise, slowly at first, then dramatically once the markets begin to really worry about possible debt default and inflation. The process may take years but getting on board this new trend reversal is potentially the equivalent of getting on board the bond market rally thirty-five years ago.
I bought TBT at 31 and sold half my position at 42. TBT has since corrected and I am back the shares I sold with this correction with a stop just under 38 on two-thirds of my position in case I'm a little early. In my judgment, there will be many such trading opportunities on interest rates to come.
Disclosure: I am/we are long TBT GDXJ.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.