Forget What the Fed Says and Listen to the Bond Market

Economists are familiar with the concept of “leading indicators.”

Those are key bits of news that give you an idea about what’s ahead for the broader economy. Rising consumer confidence, advancing stock prices and stronger chain-store traffic, for instance, often point to strong monthly and quarterly readings on retail and auto sales.

But did you know that the interest-rate markets behave in much the same way? One pattern you see consistently — over a period of decades rather than months or years — is for the bond market to lead Federal Reserve policy rather than to lag it. And that has important implications for today’s interest-rate market.

The Fed is holding what might be the most important policy meeting in years next week. Officials will gather on Sept. 17 and 18 to decide whether to curtail its $85-billion-a-month quantitative-easing program, and figure out what to say about the future direction of interest rates.

I’ve said for a while now that I expect the Fed to taper QE by as much as $20 billion, as well as reveal a plan to get out of the market entirely over the coming several months.

Ultimately, the Fed will not be able to make good on its promise to keep short-term rates low.

But more recently, I staked out an even more aggressive position. I said that, yes, the Fed may try to mitigate the impact of tapering QE by pledging to keep short-term rates low for a long period of time. But, no, it won’t have much — if any — impact in terms of taming rates for more than a very short period of time. And, ultimately, the Fed will not be able to make good on that promise.

One key factor underlying my conviction? Almost five decades of interest-rate history.Just consider:

==> In the early 1970s, 10-year Treasury yields started rising in November 1971, climbing by a full percentage point in less than a year. The Fed tried to stand pat. But it was ultimately forced to start raising short-term rates beginning in December 1972.

==> Then, in the late 1970s, as the Fed completely lost control of the bond market, 10-year yields surged from 6.8 percent in December 1976 to 13.6 percent in February 1980. The Fed was once again forced to follow the market, hiking short-term rates from 5.8 percent in August 1977 to a whopping 20 percent by March 1980.

==> Over a decade later, 10-year yields bottomed in September 1993 and started heading higher. By January 1994, the Fed was forced to start jacking up the funds rate. That led to one of the worst bond-market wipeouts in modern history.

==>In May 2003, 10-year yields bottomed out and started rising. The Fed followed by hiking the funds rate several times, beginning in May 2004.

So history not only tells us the Fed may be forced to raise rates again. It’s warning that policy makers inevitably must raise rates again. The central bank simply can’t keep short-term rates pegged to the floor when long-term rates are steadily rising, when the gap between them is ridiculously large and getting larger, and when there’s no one left in the market willing to lend the short-term money that’s needed to keep the economy alive.

I recommend you look at the chart, below, of the long-bond futures. You can see an unmistakable topping pattern that lasted for almost two years, and you can also see that we’ve clearly broken below major technical support. (That’s in the higher of the two horizontal blue lines.)

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I believe there is virtually nothing standing in the way of a further plunge to the second level of support I’ve identified — the lower blue line that sits a full 12 points lower in price. That would be accompanied by a sharp rise in long-term interest rates, since bond yields move in the opposite direction of bond prices.

Now, take a look at a second chart, below, that shows the price of the December 2015 Eurodollar futures. I don’t want to get too wrapped up in bond-market mumbo jumbo. But suffice it to say that the price of Eurodollar futures reflects investors’ expectations about the future of short-term interest rates. The lower the price of the futures, the higher investors believe future short-term rates will be.

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Sure enough, you can see that all the Fed protesting and all the Fed happy talk about keeping short-term rates low has not prevented this contract from starting to lose value. And you should also be able to see that the decline in Eurodollar futures has been nowhere near as severe as the decline in long-term bond futures … yet.

But “yet” is the key word. I believe it’s only a matter of time before the market cracks, and prices fall in the direction of the red arrows I put on the chart (on the right-hand side).

In fact, we could be on the precipice of a very sharp re-pricing about the future direction of short-term interest rates. And that opens up huge potential profit opportunities.

Until next time,

Mike