To borrow a line from Sports Illustrated, this week’s sign that the Apocalypse is upon us is Morgan Stanley’s Steven Roach changing his long held belief that a collapsing dollar will signal the upcoming financial Apocalypse of the United States because the Fed will raise rates and choke our slowing economy into recession. From Mr. Roach…
"Given my concerns over the US current account deficit, I have long in the bearish camp with respect to the US bond market outlook. A rethinking is now in order. The likelihood of a China-led slowing of Asia has prompted me to change my view. I now suspect bond yields will stay low for the foreseeable future, and I wouldn’t rule out the possibility that they might even drift lower. "
Contrarian that I am, I want to believe that Steven Roach is the highest profile bond bear who has finally turned tail. That would, of course, mean that higher rates will be upon us. However, I don’t think that’s the case and I think lower long term rates could be in offing. Plenty of investors are still betting on higher rates and it will take a while to unwind these bets and move sentiment to the bullish side.
The reason I believe Mr Roach is correct in flipping sides is that four percent long term rates aren’t out of the ordinary. One of my favorite analysts, Steve Sjuggerud at Investment University, made a great case for this last August and his analysis was right on the money – here’s an excerpt –
"There are three things that everyone believes…
Interest rates are at historic lows.
Interest rates are headed up.
Interest rates can’t go much lower.
Today, I’ll show you why all of these beliefs are wrong.
1. Everyone Believes Interest Rates Are at Historic Lows
I put together a chart of U.S. and British interest rates going back to 1720. These are long-term interest rates. You can clearly see that the average long-term interest rate, going back to 1720, has been about 4.7%.
Over the last 200 years in the U.S., long-term interest rates have been below 6%. Only during the last few decades (and for a brief moment during the founding of our nation) have interest rates been higher than 6%.
U.S. interest rates are not at their historic lows. They are in line with their historic average, around 4.5%.
In your own life experience, interest rates are as low as you’ve seen them. But that is only a few decades of hundreds of years of interest rates. Everyone else believes that interest rates are at historic lows. Now you know better.
2. Everyone Believes That Interest Rates Are Headed Up
All you hear on the news is how the Fed is going to raise interest rates. And that, of course, will most likely happen. But what interest rate is it going to raise?
This is where people get confused… Short-term interest rates are at an extreme – the Fed lowered short-term rates so banks can get money at 1%. But long-term rates, like mortgage rates, are much higher, around 6%.
Here’s where the confusion comes in… short-term rates are headed higher… they could go to 2%, for example. But long-term rates may be headed lower… mortgage rates could go to 5%, for example.
Generally, this doesn’t happen… generally, long-term interest rates and short-term interest rates move in the same direction. But the Fed lowered short-term rates to an extreme low, and has to raise them back to "normal." Meanwhile, long-term rates could easily go either way… they’re not under the control of the Fed.
3. Nobody Believes That Interest Rates Can Go Lower
Now, this is a ridiculous assumption! Let me give one simple example:
We’ve only had one other major stock market bubble in a developed country in our generation… and that was Japan’s stock market peak on Dec. 29, 1989. At the time of Japan’s stock market peak, long-term interest rates in Japan were around 6%. As the bubble has burst over the last 15 years, long-term interest rates in Japan actually dipped below 1%!
I created a chart for you today to compare interest rates in Japan and the U.S. I lined up the peak in Japanese stock market with the peak in the U.S. stock market. The similarity so far is uncanny…
Long-term interest rates in the U.S. were at 6% at our stock market peak, too. And today they’re closer to 4.5% in the U.S. – almost exactly where they were four and a half years after Japan’s stock market peak.
I’m not saying what happened in Japan will happen here. I just find it interesting that we have only one other stock market bust in a developed country in our generation for comparison. And in that country, long-term interest rates dipped below 1%!
The point is, YES, interest rates can go much lower."
This doesn’t change the problems faced from an inverting yield curve. The Fed could still push the US into a recession by continuing to raise interest rates in the face of lower long bond yields.