Saturday, December 18, 2010

Is that an economic death knell I hear?

What better time than a Saturday morning to offer an analysis of failed economic policy

When does a market change direction from bull to bear or visa versa, and how does one know that it has happened? What is only a pause in an upward surge in prices and what is a reversal in trend?

When I would give trading meetings I would often say that nothing goes straight up and nothing goes straight down. That in any move up there will be periodic pullbacks prior to a resumption upward and in any downward move there will be bounces in price along the way before heading back down.

Of course, one of the things that sets great traders apart from average traders is the instinct to know when that periodic pullback in bull market or period bounce up in a bear market is actually a trend reversal. If it sounds a little confusing it is, but there is a larger point here.

Is the bull market in interest rates over, or is this recent substantial move up in rates a temporary phenomenon?

The story is complicated and has to do with currency valuations, budget deficits, quantitative easing, imports and exports, unemployment and more. This chart gives you an idea of the rise in treasury bond yields over the past month or so, and asks the $24,000 question of whether this presages a move much higher in rates which would have devastating consequences, or if this is temporary and rates will head back down.

Below is an excerpt from an article in Forbes that discusses the situation, and I would definitely recommend taking the time to read it. That way, if the bell is ringing, you may not be the last one to hear it.

"...To stimulate after the bursting of the housing bubble (which itself resulted from the low interest rates used to juice the economy following the bursting of the dot-com bubble), the Fed lowered interest rates to practically zero. At that point, rates could go no lower. However, when that stimulus failed, the Fed decided to bring on the heavy artillery in the form of “quantitative easing,” or as it is known in the vernacular, “printing money to buy government debt.”

Lowering the federal funds rate, its traditional weapon, tends to make the most impact on short-duration debt. By its own words, the goal of quantitative easing (QE) was to lower long-term interest rates. It was hoped that this would achieve what low short-term rates had not: an increase in stock and real estate prices, a rise in household wealth, and consequently greater consumer spending, economic growth, and job creation.

However, the Fed’s plan backfired. The selling pressure on long-term bonds is overwhelming the Fed’s buying pressure. Spiking rates (which move inversely to price) are powerful evidence that the bond bubble has finally burst. The Fed threw everything but the kitchen sink at the bond market to force yields lower, yet they rose anyway. If bond prices failed to rise given such a Herculean effort to lift them up, there can be only one direction for them to go: down..."

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