A Picture is Worth....

Yes, I know. I should not use hackneyed phrases. And I shouldn't use silly words like hackneyed. But I can't help it. Anyway, I thought I would give you a break from reading my inane prose and provide some graphical information to aid in making my point. My point is this:

Wait a minute! I need to give you some background first. I was recently reading Andy Xie of Morgan Stanley's research department. When I got to the part about "I expect a big selloff in bonds" I did a double take. First of all, a lot of smart people expect a selloff in bonds, so it would be very much in the nature of markets to do the unpredictable, or at least the unexpected. Secondly, with the massive debt overhang, I am not sure I see the dynamic that will lead to an imminent bond market meltdown. What I mean is that the huge leverage that has been applied to the system is going to be a deflationary force for the immediate future simply due to weight that will be added to an already highly stressed financial structure due to even modestly higher interest rates. (I think that central bankers inherently understand this, if not explicitly.) So they will be loath to raise rates at anything like the pace we saw in previous tightening cycles. Also, Mr. Xie points to the highest inflation numbers in ten years, but we all know that these numbers for the most part are bogus! I mean who in their right mind believes that the cost of housing has been going up at a low single digit rate in the last few years! It is only because they employ such ridiculous statistical techniques, such as "hedonic adjustments" and "rental equivalency" or whatever they call the silly tricks they use to fake low inflation numbers. Now we are going to reap the harvest of our folly for the last few years. Instead of low inflation in the face of strong growth, we are going to see high inflation during a time of slow growth, which some will call "stagflation". But these inflation numbers will be artificially high, mainly due to the effects of increases in rental costs, as fewer people can afford to buy. These folks are opting, or being forced by higher mortgage rates, to rent instead of buy. So ironically, at a time when housing prices are about to come under pressure and fall (drastically, in my not so humble opinion), rents are increasing. But this is temporary, as eventually all of the supply created for sale will reach the market in the form of rentals. And when that happens, both home prices and rents will decline and we will have deflation.

"But Matt! The Fed won't let that happen! They will flood the system with liquidity and 'reflate'!" It is my contention that they will not be capable of accomplishing this feat, at least not initially. There is so much bad debt infecting the system that it will cause problems simply of its own weight and there will not be the demand to create ample new liquidity. Or put it another way, the Fed will not be able to create money faster than the market will be destroying it! (Since the Fed has been behind the curve for the last seven or eight years, I actually think that it is the dynamic of the modern financial machine that has been driving the amazing liquidity we have seen. But that engine will simply not be strong enough to drive it much further, because a boom built upon leverage and not productivity needs ever increasing amounts of liquidity just to keep at a standstill.) At some point, enough of the leverage in the system will have been cleared out so that the Fed will be able to resupply liquidity. It is at this point, that the massive bond market and US dollar selloff will materialize and we will see real inflation. But that is two years away probably. First, we will probably see a return of the ten year note to the lower end of its range of the last five years at the 3.5-4.0% level.

Finally, see the attached graph as evidence. We are near the five year highs in yields in the 5 1/2 area, which will act as resistance, if it isn't already. Especially if the Fed hikes again in August, as they very well may do, even though at the moment the futures markets are only factoring in a 40% chance of a hike at the moment. When the Fed is actually finally done raising the Fed Funds rate, the futures markets will be expecting nothing but interest rate hikes as far as the eye can see. (If I were the Fed Charman (no typo) for a day (heaven forbid!), that is what I would say: "Higher rates as far as I can see!") My guess is that it will only take one more to do the trick. 5.5% might be the magic bullet! Anyway, we will see. But if inflation is really raging out of control, then one would expect to see long-term interest rates soaring, especially when our Treasury has to dump hundreds of billions of US $ on the market every year to pay for war in Iraq, Afghanistan and anywhere else we might get sucked into. So even thought the longer term downtrend in rates may have ended in 2003, a strong uptrend in rates may not be here...yet. Take a look for yourself and decide.

For those concerned with the stock market, we are most likely seeing the proverbial "summer rally". I would expect it to run maybe another 20 points or so on the NDX before the bear's claws start mauling the tape again. But it pays to be vigilant. So while it may make sense to use the next two weeks or so to establish some shorts, lighten up on any longs (the drugs may be selective exceptions here, but probably not, unless you HAVE to own something!), be careful and use 1520 as a stop, since I would not expect 1510 to be breached in any significant way. The averages are all under their moving averages, so it will take some real work to change the picture. The last two days of rally are nice, but anything can happen on two days. With Amazon announcing bad results, we are in for a few bad days before we get another rally and that will be it, most likely. And then the traders will return from their vacations and mark down their goods in September and October in anticipation of a Santa Claus rally and poorer economic results in the year ahead. With that thought, have a nice day!