Viewing Interest Rates Through the Looking Glass

Wow, did I stir the pot with my Money and Markets article last week.

As evidence that interest rates are headed down, I showed a chart from the Financial Times that showed how foreign purchases of U.S. Treasuries are beginning to tail off.

In looking through the comments section about the article, it’s obvious that I sent some readers’ heads spinning.

For example, Joe posted:

“There’s an inverse relationship between bond yields and bond prices. If Treasury bonds are being sold, it stands to reason the price should fall and yield rates should rise.

Please straighten this out Bill —  I Gots to know!”

Joe’s post is important to address because if you are a regular reader of my Money and Market’s column, you know that the one key metric that I am focused on to signal the direction of the stock market is the yield on the 10-year U.S. Treasury.

That’s because this top-of-the-food-chain interest rate is the key for pricing assets across the board. Yes, the yield on the benchmark 10-year U.S. Treasury sets the prices that investors are willing to pay for everything, ranging from bonds to stocks to commodities to real estate  …  it will even tell you the direction of the global economy.

In a nutshell, in the current environment, falling interest rates mean lower stock prices. On the other hand, rising rates signal that stocks are headed higher.

The most important statistic for investors is the interest rate on the 10-year U.S. Treasury bond.

I was spot-on in my March 17, Money and Market’s article when I predicted that intermediate and long-term rates were headed lower, despite the Federal Reserve hiking the discount rate on the short-end of the yield curve. Indeed, longer-term rates have moved lower since the Fed’s announcement, with the yield on the 30-year U.S. Treasury now below the magical 3 percent threshold.

And just as I expected, as interest rates have begun to fall, the stock market has pulled back too.

Simply put, that’s why you need to keep an eye on the 10-year U.S. Treasury yield.

Now, turning back to Joe’s comment. In theory, he’s correct. There is generally an inverse relationship between bond yields and bond prices. And, foreign selling of U.S. Treasuries would commonly cause yields to rise and bond prices to fall.

But the bond market, like all financial markets, is a complex ecosystem. So general rules don’t always work, especially when central banks have caps on how much they can hold in any one country’s government debt. Making it even more complicated, central bankers must make relative-value assessments when comparing one sovereign credit with another.

So to stay out of all this detail and avoid the complexity, I recommend that you simply watch the yield on the 10-year U.S. Treasury. That’s because this one simple, easy-to-find market metric can tell you more at a glance than reading multiple financial publications, sifting through countless articles on the Internet or spending hours watching financial programming on television.

Now here’s another chart that shows why U.S. interest rates are likely headed lower. And it’s a lot easier to intuitively understand than mucking around in the dregs of international currency flows and foreign central bank bond holdings, as I did last week.

It’s a chart that shows the yield on the 2-year German Bund. The 2-year Bund is the German equivalent of our 2-year U.S. Treasury.

At first glance, you may think that I’ve gotten this wrong, too!

That’s because yields on 2-year German debt fell to an all-time record low of MINUS 0.92% in late February before settling at the current yield of about MINUS 0.80%.

Yes, that’s NEGATIVE 0.92%. That means investors are willing to accept a NEGATIVE return in exchange for the safety of holding short-term German government securities. That’s shocking! As a 30-year Wall Street veteran, I have never seen anything like it and you can see it here for yourself.

The mere concept of negative interest rates caused quiet investment giant Seth Klarman, founder of Baupost Group, the world’s 11th largest hedge fund, to say this in his most recent market letter:

“Currently, there’s about $13.4 trillion of debt worldwide (largely sovereign) traded at negative interest rates, a mystifying and unprecedented circumstance in which bondholders willingly subjugate themselves to pay interest to issuers for the privilege of tying up their capital for a significant interval while still bearing the risk of default.”

And, we think the yield on our 2-year U.S. Treasury of 1.24% is skimpy. Well, at least it’s positive for now but it’s likely to go lower as signaled by the most solvent sovereign credit in Europe.

So with stock prices likely to follow interest rates lower, maintaining a high cash reserve — to fund future buying opportunities when the market does indeed come back — continues to have high investment value. It may not be the most enticing investment option I ever put before you, but it is a clear reflection of today’s reality.

Best wishes,

Bill Hall

P.S. In my newsletter, Safe Money Report, I provide you with crystal-clear views of the financial landscape and how it will impact your financial future. Specific guidance on “what,” “when,” and “how” to buy. Updates on all recommendations, including the go-ahead on precisely when to take profits while protecting your principal. Ratings and insights on the good, the bad, and the ugly in the banking, insurance, and brokerage businesses. Read more here …

Bill Hall is the editor of the Safe Money Report. He is a Certified Public Accountant (CPA), Chartered Financial Analyst (CFA) and Certified Financial Planner (CFP). Besides his editorial duties with Weiss Research, Bill is the managing director of Plimsoll Mark Capital, a firm that provides financial, tax and investment advice to wealthy families all over the world.