The bond market is probably the most important market in the world, not only because it is the largest but also because everything else is priced off the interest rates it sets. Six months ago, the debt markets were setting those interest rates at multi-century lows. Then, something changed in early July and the bond market started trending down (rates started to go up). The losses on these bonds have been massive. It is beginning to look to me like the central banks are losing control of the debt markets and that would be a very big deal.
All the major central banks have used QE (purchases of debt) to keep interest rates down. This policy worked in part because investors generally perceived that the environment was deflationary, so there were lots of players willing to front-run QE purchases. In turn, this low-rate policy kept stock and housing markets elevated and moving higher according to plan.
Now, however, the deflationary psychology appears to have evaporated and the markets are beginning to expect more inflation. Bonds are no longer in favour. It would now be extremely hard for the central banks to muscle rates back down should they choose to do so. That means big trouble ahead for stocks and housing.
These Are Not Small Potatoes
U.S.10-year yields reached 2.62% this week, an increase of around 65% since the beginning of October and 91% since the low on July 8 of this year. These moves are enormous…much larger and faster than when Reagan was elected. In the 12 months from October 1980 until the low in October 1981, yields “only” rose 41%, enough to help trigger a nasty bear market in equities. Meanwhile, today the stock market’s P/E ratio is about two-and-a-half times higher than in 1980 and U.S. housing prices have just hit new all-time highs. These markets are very vulnerable to higher rates no matter what magic Trump may have at his disposal.
The implications are starting to appear. This morning, we got some very bad news from the housing sector. November’s data collapsed in line with the recent downdraft in mortgage applications. Housing starts crashed 18.7% month over month, very nearly the biggest monthly plunge since the previous housing market peak in 2005.
Housing starts are now down 6.9% year over year. Remember, the housing sector is a major component of GDP.
Falling bond prices are also attracting sellers in the world’s biggest bond market. In the latest monthly update (October), offshore central bank sales of U.S. Treasuries in the last twelve month period (ending September 30) reached a new all-time record of $403 billion. As the chart below shows, we have never seen such aggressive selling of US Treasuries over a 12 month period. The biggest seller? China.
Trump needs a strong debt market to fund his massive spending and tax cut plans. Rising rates and aggressive selling are not going to be helpful, especially at a time when other central banks are starting to cut back their QE. I smell trouble, dear reader. So far, the stock market has ignored the rising rates. But not for much longer, in my view.