Higher For Longer.
The Pain That Rising Rates Is Causing.

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Happy late summer Gaugers.  We all hope you continue to take advantage of the warmer weather and are enjoying late summer’s lazy dog days.

Interest rates pushed higher yet again this past week.  This trend has caught the attention of positive sentiment and stock-happy Wall Street.  A move higher in Treasuries has pushed 10-year yields close to their highest point since 2007 and spurred what is now the biggest break in an $8 trillion equity rally since last October (2022).

See charts below of the 10-year and 30-year bond yields towards the end of the week.

There are a number of catalysts for this rise in rates, including:

• A larger than expected Treasury supply meeting with a lukewarm appetite for these securities. The Federal Reserve is not buying (they are selling which is exacerbating the supply).  China does not seem to want them.  Other countries have begun converting to using their local currencies for oil purchases (such as the Yaun or Renminbi) do not want to put their local money into US Dollars or Treasuries.  So rates are rising to spur more demand.
• The recent Fitch and Moody’s downgrades may be viewed as “irrelevant”. However, the criticism conveyed to the rest of the world is a real concern for US debt and deficits.  This had the effect of downgrading credit quality, which is most often met with higher rates as compensation for the additional risk, if any, that will be taken.
• A still hawkish Federal Reserve that continues to see strong growth in the US economy. This week they talked about the possibility of more rate hikes.  On Wednesday, the Federal Reserve minutes were released. The immediate response was rising rate expectations.    Here is a summary of those minutes:
  1. Most officials still see the need for higher rates
  2. Although some officials do worry about over-tightening
  3. The Fed sees tighter bank credit conditions.
  4. The Fees sees no recession in 2023.
  5. The commercial real estate value decline is hurting some banks.

• A US economy that has yet to show the necessary strain of more than 5 percentage points of rate hikes. A continued series of solid data points have pushed Citigroup Inc’s US economic surprise index to close to its highest level in nearly two and half years.
• GDP expectations which have been adjusted upward several times in the past year. GDP for the 2^nd quarter came in much higher than expected (2.4% vs 1.8%) and the upcoming quarter estimates have been adjusted upward.  Growth is on solid footing.
• The Atlanta Fed GDPNow tool is now forecasting Q3 2023 GDP growth at a massive 5.8%. This is more than double the 2.5% expected by JP Morgan.  It is almost triple the 2.1% expected by Blue Chip Consensus.  Does the bond market know something about upcoming dramatic growth in the US that the average economist doesn’t?  See chart below:

• This economic resilience and the expectation that it will likely continue, has helped explain why both the 10-year and 30-year bond yields continue to climb. (see first two charts at the top of the article)

The Fed has doubled down on its view that a recession is no longer likely.  This has caught the attention of the bond market as it now struggles with the GROWTH story.  However, they do acknowledge that we are in a commercial real estate crisis.  If the FED can avoid a recession after the dramatic and unprecedented historical tightening they have instituted during 2022 and 2023, that would be IMPRESSIVE!

It is interesting to look at the longer-term picture (24 years) to see that the dominant bond market trend has been broken.  See chart below:

MarketGauge’s own Mish Schneider works closely with a brilliant analyst, David Keller (Chartered Market Technician) at Stock Charts.  Just this week he provided his own technical analysis of bonds.  His view (shown below) is that the 10-year yield is showing signs that it can drift higher, perhaps hitting 5%.  This might be what the Fed needs to have happen to finally slow down the economy.  See chart below:

There have been numerous areas of the economy that have seen unparalleled damage (pain) from these rising rates.  Here are a few:

Mortgages, and Home Buying:

• This week the average interest rate on a 30-year mortgage rose to its highest level since 2003, at 7.4%
• 2 years ago, buying a $500,000 home with 20% down meant you paid $207,000 in interest on a 30-year mortgage. Now buying the same home means you pay $600,000 in interest on a 30-year mortgage.
• In many states mortgage rates are already over 8%. See graph below:

• In 2020 you could afford a $758,000 house with a 20% down payment on a $2,500 month 30-year mortgage. Now you can afford a $443,000 house with 20% down on a $2,500 a month 30-year mortgage.   See chart below:

• Housing affordability just hit a new low. See chart below:

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Renting a Home:

• Renting a house has become even more expensive. The average “asking” rent for a house in the US rose again in July to $2,038 a month.
• Less than 3 years ago, the average asking rent in the US was at $1,600 a month, 27% below current levels.
• The median payment on a mortgage just hit a record $2,800 a month in the US.
• Simply living in the US has never been more expensive. See the asking price for rent in the chart below:

Inflation

• Rising interest rates continue to have a profound impact on everything from energy to food prices to mortgages and rising rents (including Apartment rents).
• While overall inflation is now at 3.2% simply having a house to live in (as shown above) is incredibly expensive.
• Inflation on shelter is still at an alarming 7.7%
• Meanwhile, looking to enjoy a meal at a restaurant? Inflation is still at 7.1% for food away from home.  Inflation has made simple things, that we may have taken for granted, a luxury.

Debt

• Total mortgage debt is $12 trillion, now more than double the 2006 peak.
• Record $1.6 trillion in auto loans
• Record $1. Trillion in credit card debt.
• Record $1.6 trillion in student loans.
• 36% of Americans have more credit card debt than savings while student loan payments are set to resume this fall for the first time since 2020.
• There is a record 17.1 trillion in household debt.

The amount of debt is alarming and rising interest rates have exacerbated the pain of repaying back credit as the interest rates on credit cards have ballooned to the high teens to 25%.  See chart below of delinquency of debt:

Rising interest rates help support the US Dollar.

As is typical when interest rates rise and higher yielding instruments (US Treasuries) attract more worldwide buyers, the US Dollar tends to gain strength.  This is more often a negative for multi-national companies as their revenue from global sales can be hampered (a weaker US Dollar is often better for selling goods overseas).

As we witnessed throughout 2022, a stronger dollar was not beneficial for stocks.  If you have been a long-time reader of this weekly Market Outlook, you know that we have illustrated on numerous occasions the negative effect a strong US Dollar has had on US stocks.  Therefore, it is not surprising to see additional volatility and a pullback in US stocks during August with lower volume, interest rates that are trending up, and higher volatility.  See US Dollar chart below:

It is also not surprising then, to see a stronger money inflow to bonds/fixed income ETFs then stock ETFs.  See chart below:

If you look closely at the chart above, you will also notice large inflows to stock ETFs (black bar) during a few of the best performing stock market months over the past year (Oct, Nov & December 2022, and May, June, and July 2023).

The bond market: the great disruptor.

We have frequently written that there is usually a healthy balance between the fixed income markets and stocks.  Typically, bonds have a low correlation to stock market performance and vice versa.  This is why many conservative investors (or those who think they are), will use a balance of stocks and bonds.  It is also why so many 401k investors, no matter their age, use some blend of stocks and bonds.  The bonds are put in the portfolio to create income and more importantly, to balance out the risk of the stock market (as measured by potential drawdowns).

This is also why the preponderance of retirement plans, even large ones, have a healthy balance of stocks (usually 60%-75%) and bonds (usually 25%-40%).  Until last year, one of the worst years for the bond market (and bond funds and ETFs) due to rapidly rising interest rates.  Nobody expected that the average bond fund (investment grade) would be down over 10% in 2022.  Given their max 2022 drawdowns, bond funds/ETFs looked more like the stock market than the bond market.

This is why rising interest rates have a negative effect on stock market prices as they did during 2022 and more recently at the beginning of August.  Additional reasons why bonds compete for stock investments are as follows:

1. Rising yields on bond funds pull $ away from stocks as investors begin to see the benefit of “locking in” higher yields.
2. Rising interest rates have a detrimental effect on company’s earnings if they have to pay higher bond interest on their debt. This will surely cut into their earnings power.
3. Investors begin to see unrealized capital losses on their fixed income securities. When this happens, it begins to motivate investors’ to pull in their speculative capital as they fear a major drawdown could occur with the rest of their account’s holdings.
4. When “fear” begins to permeate into the stock market (VIX rises), investors will begin moving money from their “speculative” portfolio to one that has risk free yields (currently an attractive 5%). This is especially true if they have a portfolio of quality stocks earning dividends below what they can earn in short-term fixed income securities.
5. Wall Street analysts have begun to adjust their earnings expectations and inevitably their stock price forecasts. They have begun to factor in the higher cost of business.  This could include higher rents, transportation costs, manufacturing costs, labor costs, and raw materials, all directly or indirectly affected by higher interest rates and higher financing rates.

Fixed Income is getting more attractive.

As shown in the ETF inflow chart above, investors are starting to put capital into fixed income ETFs and funds.  Most investors are hoping that the Federal Reserve’s actions over the past two years will finally kick in and cause the market to slow down.  We try and share with our subscribers and asset management clients that hope is not a good strategy.

There is an increasing realization among bond traders that the rock-bottom yields of recent years are likely gone for good.  Those who had bets on longer-dated Treasuries have seen them backfire as the US economy stayed resilient.  However, soon they may see their luck turn, according to Schroder Investment Management’s Sebastian Mullins.  He sees signs of weakness despite recent strong data.  He along with a large swath of other investment managers are looking for an entry point to begin buying these longer-maturity Treasuries.

What about the Stock Market?

We are currently experiencing a market pullback and consolidation.  Not surprising given the significant returns of the stock market, especially tech stocks through July 31.  Since the beginning of August, the NASDAQ 100 (QQQ) is down 6.6% and the S&P is down 4.6%.  Not a huge unwind (yet).

Over the last week (5 trading days), both indices are down about 2.2% for the week.  Surprisingly, technology (XLK) was the best performing of all the sectors last week.  See the recent chart below:

What the above chart tells us is that the growth areas of the market are still seeing the best performance and areas, like financials, real estate and consumer discretionary sectors may be pricing in the detrimental effects of rising interest rates and any possible future Fed action.

A significant part of the last twelve months’ stock market rally has been about cooling inflation, continued good earnings growth and eventually the Fed ceases to raise interest rates.  If, according to Mr. Mullins, above, we could see actual signs of weakness.

This would translate into interest rates peaking, the US dollar weakening and a resumption of a positive stock market again.

The month of August.

Since the end of July, we have experienced a minor stock market correction.  This was expected by Wall Street professionals and market prognosticators. Most cited typical stock market weakness in August coupled with the expectation that a consolidation was needed, especially after stocks are ahead by 10% or more for the first 6 months.  We offer a few charts to emphasize these facts:

 

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Normal action.

Finally, we include two charts from two of our favorite market commentators, Callie Cox and Ryan Detrick (of The Carson Group).  Both of their illustrations provide ample proof that we are simply experiencing a normal pullback in a bull market.  See charts below:

Now here are the BIG VIEW summary points that Keith and his team put together for this week:

 

 

Risk-On

• Semiconductors (SMH) and Technology (XLK) actually performed the best this week relative to the other market sectors as they were down only -0.1% and -1.2% respectively and could be a lead indicator that the market is flushed out (+)
• Market Internals for the S&P 500 and Nasdaq Composite as measured by the McClellan Oscillator is looking overdone to the downside. It ticked up on Friday indicating that a mean reversion trade to the upside may be setting up. (+)
• Sentiment readings according to the number of stocks that are above the 10-day moving average are showing short-term oversold readings in both the S&P 500 and Russell 2000. (+)
• US Oil (USO) has achieved its first golden cross on the daily timeframe since December 2020 and is now in a bullish phase for the first time in nearly a year. (+)

Risk-Off

• Volume Patterns show distribution days outnumbering accumulation days across all 4 key US indices over the past 2 weeks, however, both the S&P 500 (SPY) and the Russell 2000 (IWM) put in accumulation days on Friday despite relatively flat price action. (-)
• All major market sectors closed down for the week led by Consumer Discretionary (XLY) and Homebuilders (XHB) each down more than 4%. (-)
• Alternative Energy ETFs including Clean Energy (PBW) and Solar (TAN) which are more speculative sectors led the selloff this week and closed more than -7% each. (-)
• The 52 Week New Highs / New Lows ratio continues to deteriorate and is not oversold for either the S&P 500 or Nasdaq Composite. (-)
• Cash Volatility ($VIX.X) remains elevated and put in a new 3-month high this week. (-)
• Intermediate to Longer-term Interest Rate (TLT) looks to remain under pressure and are below key support levels after a continued drop this week. (-)
• Value stocks (VTV) continue to maintain short-term leadership relative to Growth stocks (VUG). (-)
• Foreign Equities broke down hard across the board with both Emerging Markets (EEM) and Established Markets (EFA) both closing below their respective 200-day moving averages, as well as both EEM and EFA continuing to underperform relative to US equities. (-)
• Even with Soft Commodities (DBA) closing in a weak warning phase, they continue to outperform equities on a relative basis and actually closed above its 10-day moving average on Friday. (-)

Neutral

• All four key US indices closed down this week with Small Caps (IWM) leading down -3.32% moving into a warning phase across every index for the first time since February, however, all four indices are also now showing oversold levels on both price and momentum according to the RealMotion indicator and may be due for some mean reversion. (=)
• Risk Gauges backed off to Neutral after an extended period in Risk-On mode. (=)
• Two key highlights from Mish’s Modern Family include Semiconductors (SMH) have held June lows despite a continued drop this week, while Regional Banks (KRE) may be a leading indicator if it can hold current levels as it is at a significant inflection point sitting just above the 50-day moving average on price, and just above the 200-day moving average on RealMotion. (=)
• On a longer-term weekly timeframe, DBA has been outperforming the S&P500 since the beginning of 2022. (=)

Thanks for tuning in. If you would like more information about our lineup of Investment Strategies and Portfolio Blends, please contact Rob Quinn our Chief Strategy Consultant at  [email protected]. Or if you want assistance managing your assets through our asset management affiliate company (MGAM) using a blend of our investment strategies, please reach out to me [email protected] or Ben Scheibe at [email protected].