The Participant 8/5/15: Interest Rates

by Jason Kelly

Wednesday, August 5, 2015



Bill Gross, now at Janus Capital in Denver, wrote in his July 30 Investment Outlook that the Federal Reserve and other central banks have historically “relied on a model which assumes that lower and lower yields will stimulate not only asset prices but investment spending in the real economy. With financial assets, the logic is straightforward: higher bond prices and stock P/E’s almost axiomatically elevate markets …” Real wages have not risen, however, nor has lowering the cost of debt toward zero resulted in higher capital spending in the real economy — or boosted much of any business activity.

Gross wonders if we’re witnessing not so much the failure of low rates to boost the economy, but rather damage to the economy and markets caused directly by those low rates. Among other problems, “because of low interest rates, high quality investment grade corporations have borrowed hundreds of billions of dollars, but instead of deploying the funds into the real economy, they have used the proceeds for stock buybacks.” This robs the economy of the boost it needs while also elevating stock prices beyond fundamental support.

The Bank for International Settlements (BIS), the so-called central banks’ central banker, agrees, writing that “persistent ultra-low interest rates … sap banks’ interest margins … cause pervasive mispricing in financial markets … threaten the solvency of insurance companies and pension funds … and as a result test technical, economic, legal and even political boundaries.” The latter is presumably a nod toward Greece.

An end to ultra-low interest rates in the United States is nigh, we’re told. Expectations are for the Fed to raise rates at either its September or December meeting. Gross votes for September because he thinks the Fed and others are wising up to reality: “Low interest rates are not the cure — they are part of the problem.”

If and when rates do finally begin to rise, what should we expect? Mainstream financial media have been beating the “end of bonds” drum for more than two years now, but have been wrong as bonds and bond funds fared well. Will they be right one of these months? Barron’s thinks so. Its cover three weeks ago read, “Trouble Ahead For Bond Funds.” The media’s game plan is to keep running the same story until it’s finally right.

Yet, the worry that bond prices will fall is missing a key point, according to history. From The Kelly Letter Note 8 sent to subscribers on March 1: “Is it wrong to use bonds for safety heading into a rising interest rate environment? No. … Throughout history, income from bonds has provided some 90% of their total return. Why this fact is absent most discussions about bond fund timing is beyond me, but it is.”

Following the June 2013 FOMC meeting in which then-Chairman Ben Bernanke suggested it might be appropriate to begin “tapering” quantitative easing later that year, bonds were widely sold, sending their prices down and yields up. This was the “taper tantrum.” A closer look at where the damage happened indicates the term premium was most affected. The term premium is the difference between a long-term bond’s yield-to-maturity and a short-term bond’s. Because there are more interest payouts (coupons) from the longer-term bond, its yield-to-maturity should be higher. This difference grew in the taper tantrum, revealing that the sharpest drop in demand occurred in long-term bonds.

This confirms that longer-term bonds have a higher duration than short-term bonds, meaning they are more sensitive to interest-rate changes. For this reason, I recommended using medium-term or total-market bond funds in “The 3% Signal” as a place to safely store capital for buying power into stock-market downturns. They are the sweet spot of the bond market, offering the right balance of rate risk and yield.

Will bond prices fluctuate when rates rise? Of course they will, but not by nearly as much as stocks fluctuate. Any price decline in bonds or bond funds will eventually be offset by steady distribution payments. Plans that move capital into and out of bond funds in response to price signals will put the fluctuation to work by automatically buying more shares when the price is cheap.

Managed properly, rising rates need not be feared — not even in the one asset class the media uses repeatedly to attract attention to this drawn-out story. Where exactly did people expect rates to go from zero?



From Note 27 sent to subscribers last Sunday morning, with data as of Friday, July 31:

Don’t look now, but Google+ (GOOG $626) is finished. The social networking site launched four years ago to compete with Facebook (FB $94) was unable to make progress. After a strong initial growth spurt as people signed up to try the new alternative, engagement withered when users discovered it was too quiet to make posting worthwhile.

Momentum investing systems are flagging US small-cap stocks as a leading asset class currently, a vote that seconds our long-term commitment to the class in Tier 1. Our use of mid-caps in Tier 2 is also supported by this finding due to their more closely mimicking the behavior of small-cap rather than large-cap stocks.

So much for the gathering bear market of a week ago. The scaremongers enjoyed just a single weekend of perdition prediction before the indexes fired off another V-shaped recovery and the usual list of doomers slunk back into hiding. What does it take to prove these guys right once in a while? Will we ever get the genuine price crash we’ve been craving? We want one to draw safe capital into depressed prices in our stock ETFs in Tiers 1 and 2. It’s been so long since anything meaningful has happened on the downside that media have resorted to calling flutters like the S&P 500’s 2.3% drop from 2128 on July 20 to 2080 on July 24 a “crash.” How wet behind the ears are these commentators? If that’s a crash, then a bacon bit’s a stuffed pork chop.

Past market struggles for Exxon Mobil (XOM $79.29) occurred in 1973-74, 1980-82, 2000-02, and 2008-10. It exhibited a pattern of bottoming after declines of 40-45% over two years. From its peak at $104.76 in July 2014, it’s currently down just 24% in one year. Whether this means oil stocks are only halfway through the current bear market or that this bear market is less severe than past ones is an open question. However, the bulk of oil analyst commentary and company reports suggest the former.

Once the excitement of going from Windows 8 directly to Windows 10 wore off, everybody wondered why it mattered at all. They’re still wondering. Even Windows Insider’s attempt to compliment the new OS revealed a lack of imagination in the product: “This combines the strengths of Windows 8 with Windows 7.” That’s progress? It strains the definition of “new.” The lack of excitement on the PC front reveals a weakness in Intel’s (INTC $28.95) current business model. A large part of its sales potential depends on the ability of Microsoft (MSFT $47) to get people excited about PCs, and Microsoft is a known disappointer on this front.

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The following forecast is from Jim Paulsen’s appearance on CNBC two weeks ago.

Paulsen got cautious on US stocks at the end of last year and predicted a sideways 2015, which has come to pass so far, with the Dow Jones Industrial Average up about 1.5% this year based on Friday’s close. …

Acknowledging the upswing in stocks, Paulsen said the market could go higher in the short term. “But we may get a full blown correction yet,” he warned, pointing out it’s been the “third-longest period in post-war history without a correction.”

“The big event is yet to come, and that’s the [Federal Reserve raising interest rates], and I think it’s going to happen this year. … I guess I lean more toward September … We’re going from the mother of all monetary easing cycles, we’re now finally going to turn the monetary boat for the first time. … To think we’re just going to skate right through that seems unrealistic.”

I characterized the disposition of this call as “Short-Term Bearish” for the S&P 500, and scheduled it to be judged on October 20.

To see this call in The Z-val Zone, please visit:

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Background: The term “z-val” is a shorthand introduced in my book, “The 3% Signal,” for “zero-validity forecasters” and “zero-validity environment.” The latter phrase was coined by Nobel Prize winner Daniel Kahneman in his book, “Thinking, Fast and Slow,” where he wrote that “stock pickers and political scientists who make long-term forecasts operate in a zero-validity environment. Their failures reflect the basic unpredictability of the events that they try to forecast.” This is why stock market forecasters are proven to sport an accuracy rate of about 50%, same as a coin toss, yet they continue forecasting.

You can peruse the growing collection of tracked forecasts in The Z-val Zone at:

Seen a forecast I should track? Send me the link.



HitchBot was a talking, tweeting, hitchhiking robot that tried to traverse continents with the help of people. Its Canadian creators considered the project a social experiment to see if robots can trust humans. The answer: No. At least, not in Philadelphia.

The kid-size droid hitchhiked its way across Germany, the Netherlands, and Canada without incident, then survived just over two weeks and 300 miles in the United States before being beaten beyond repair and abandoned on a street in Philadelphia. The bot was a congenial travel companion, sharing bits of trivia and engaging in limited conversation, and relied on the kindness of strangers to move from one place to another. It could not move on its own. Who destroyed it or why remains a mystery, but a short video exists showing a punk in a sports jersey and backwards baseball cap repeatedly kicking it.

HitchBot’s team is putting a good face on the unfortunate conclusion to the first phase of its experiment, mostly out of concern for the many schoolchildren who’d been following the bot’s path on a website and social media. The team said it will not try to find who destroyed the droid. HitchBot’s final message on the project website read, “Oh dear, my body was damaged, but I live on back home and with all my friends. I guess sometimes bad things happen to good robots! My trip must come to an end for now, but my love for humans will never fade. Thank you to all my friends.”

As robot technology improves and people worry about the rise of the machines, this incident poses a question: Should humans fear the machines, or machines the humans?

Yours very truly,
Jason Kelly

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