Memo to Brae Head Clients
There is a tug of war going on in the bond market. Central banks the world over have lowered interest rates to near zero and even below. The initial objective - to insure liquidity to the financial system in 2009 – has succeeded. The second objective – to stimulate growth – has failed. Here in the U.S. gross domestic product is estimated to grow only 1.2% this year.
One of the effects of such low interest rates has been to support the stock market. There is no place else to go for yield. And yield, increasingly, is replacing growth in total returns. The driver of growth is earnings and corporate earnings are down over 15% from a year ago.
Another effect of low interest rates, apart from the impact on savings accounts, is the effect on government pension obligations. As underfunded as they are already, low investment returns exacerbate the problem. Another significant impact of low rates is the effect on insurance policies which values are directly connected to the level of interest rates.
There is no question that interest rates will rise, only when and by how much. Increases will exacerbate American debt service and fiscal conditions in general. Monetary policy is exhausted.
In the last 5 trading sessions the yield on the 5, 10, and 30 year U.S. Treasury securities has increased approximately 12%. The bond market is in a significant correction and this will probably continue. This should precede a stock market correction. The S&P 500 hit 2,193 on August 15th, an all-time high. A 10% drop from there is 1,974. Close today was 2,127. Significant support is at 2,050. At 2,000 I would be a committed buyer. We have bought very little recently except for a few exceptional values.
The end of August through mid-October is the most volatile time of the trading year. Sharp moves can be expected – in either direction. Volatility has been non-existent until the last 5 trading sessions. The VIX (volatility index) has moved from 11.94 on 9/7 to 17.85 today. There are significant changes ahead and they will present opportunities. If the change in interest rate direction is dramatic, the pace of change likely will not be.
Dennis M. O’Connor