Gary Dorsch: Exploding Deficits, Rising Rates Put U.S. Market In 'Dangerous Territory'

By FS Staff

We saw volatility return in a big way in February, and it appears to be back as of last week.

This time on the Financial Sense Newshour, we spoke with Gary Dorsch of Global Money Trends for his take on the recent market action, and whether it signals something more ominous for markets on the horizon.

Signs of Stress

As of March 9^th, we'll be 9 years from the beginning of this bull market, Dorsch noted. This is the second-longest bull market in history, and if it can continue its upward trajectory until August, it will be the longest bull market in history.

What we're left with is an aging bull market in its later stages, he noted. And yet, despite the incredible vigor we've seen from this market, what we witnessed may have been the euphoria-mania phase at the tail-end of the bull.

The recent capitulation in December and January from resistant retail investors entering en masse was taken as a signal by contrarians that we were near the end of this bull market, Dorsch noted. This fueled the violent moves we saw in February.

"Volatility has come back with a vengeance," Dorsch said. "Volatility is a code word on Wall Street for heavy selling. It's no longer going to be an escalator ride. It's going to be a violent, bumpy two-way market."

Two Forces Driving Markets

There are two main considerations right now on the buy side, Dorsch noted. The tax cuts have given a handful of S&P 500 companies access to trillions of dollars from overseas. They're likely going to use this money to buy back their own stock.

"Already, there are estimates from Goldman Sachs and J.P. Morgan that the S&P 500 companies may spend anywhere from $650 to $800 billion this year on buybacks," Dorsch said. "That's what I call corporate QE. Corporations buying back their own stock are the biggest buyers and defenders of this market."

The other force at play is the Fed's trajectory on interest rates. Unlike in previous years, those buying this market will be fighting the Fed.

The Fed is going to continue on its gradual path of raising interest rates, Dorsch stated, and, more importantly, will continue with quantitative tightening, allowing around $420 billion of its bonds to roll off its balance sheet in 2018.

If this continues into next year, we would see a $600 billion drain through quantitative tightening.

Rate hikes require drainage of short-term money to sustain high rates, and at the same time the European Central Bank will be exiting from QE at the end of September, Dorsch noted. Japan is likely to be the only central bank still easing this year, and we may see stealth tightening from it as well.

"If interest rates go significantly higher, it will completely negate the benefits of these tax cuts," Dorsch said. "The market's going to have a very tough time with that."

Interest Rates Heading Higher on Rising Debt Levels

So far, interest rates have been vital to equity market health. The day the S&P 500 closed at its all-time highs on January 26 at around 2874, was the same day the 10-year U.S. Treasury yield penetrated 2.65 percent. Fears of higher interest rates were behind last week's sell-off.

"That's a key level, because that was last year's highest level of the year," Dorsch said. "Once the 10-year took out last year's high, the computer algorithms set off the alarms. … We're already in dangerous territory, because having taken out last year's high - at 2.65 and moving up to 2.95 and back down to about 2.85 today - that was the main trigger that touched off the selling."

All of this has led to remarkable volatility. If the 10-year yield goes above 3 percent - and Dorsch predicts it will hit 3.25 to 3.5 percent - the amount of debt that the Treasury is going to have to sell is staggering.

It's inevitable that interest rates will go higher, Dorsch stated. The debt will hit $1 trillion a year for each of the next few years, and the only way to finance it is with foreign money, which will require the Fed to raise short-term rates to keep the dollar steady.

"Now we're caught in a trap of our own making," Dorsch said. "The market went up on the positive aspects of the tax cuts, and we all know what the positives are. Now we're going to start to see the negative implications of these massive tax cuts in the form of trillion dollar budget deficits for as far as the eye can see, along with much higher interest rates."