What Happens If The Fed Is Wrong

• Erie comparisons to 1929
• Credit spreads worsen
• 30-year bond yields break down prices break out

When the fed raises interest rates after a long series of declines it usually signals a change in policy and the start of a new trend to higher rates. What happens, though, when the Fed gets it wrong and prematurely raises rates? I think we are about to find out.

Why do I think they have hiked short-term rates prematurely? Take a look at Chart 1, which compares the yield on 3-month commercial paper with commodity prices. The arrows clearly show that in the past there have been genuine inflationary reasons for hiking rates as their cyclical lows have consistently been led by a trend of rising industrial commodity prices. However, the two red arrows show that rates have recently been rising in the face of sharply declining commodity prices. Thus, the usual reason for raising rates i.e. inflationary pressures are starting to build is just not the case right now. My suspicion is that the authorities have tried to raise rates because they need declining rates in their toolbox to help stimulate the economy when the next recession inevitably comes. At zero, that’s just not possible. The problem is that raising rates when the economy is clearly slowing will just induce that recession sooner. We wonder why the stock market is so nervous! It’s sensing that the central bank is stepping on the brakes when there is no gas left in the car.

Chart 1

Going back through history I can find very few examples that compare to today. The only really comparable situation is shown in Chart 2, which compares the relationship between commodity prices and interest rates during the 1920’s. Note how commodities behaved normally by topping ahead of rates in 1920 and bottoming ahead of them in 1921. However, come 1924, when rates bottomed they ran up for a full five years on the back of a slowly declining commodity market.

Chart 2

Chart 3 shows that stocks peaked just a little ahead of the time when commodities began their sharp sell-off. In effect, we had rising rates and a message being given by commodities that the economy was too weak to withstand them. Obviously the stock market obliged with a decline.

Chart 3

Fast forward to Chart 4, which shows that a similar pattern has been developing in the last few years. Commodities peaked 5-years ago in 2011 and the yield on 3-month commercial paper has been rising for a couple of years in anticipation of a Fed hike. Now we see the stock market responding by tentatively completing a top. I use the word  “tentatively” because this is a monthly chart, and we are not at the end-of-the-month yet. Nevertheless, those who read my “Please Show Me a Bullish Chart” article last weekend will appreciate that the global equity scene is extremely vulnerable at present with widespread breakdowns throughout the world. I want to stress that I am not forecasting another 1929, merely pointing out the similarities and the fact that the market looks increasingly vulnerable.

Chart 4

In any event, Chart 5 shows that the NYSE Composite ($NYA) has completed a head and shoulders top on the daily chart. That breakdown is likely to be a valid one because Chart 6 indicates that Wednesday’s action represented a consolidating, outside bar.  An outside bar develops when the trading of the session totally encompasses that of the previous one and closes in the direction of the prevailing trend. Since the current trend is down and the close developed pretty near the day’s low, Wednesday’s action qualifies. In this case, the outside bar encompassed both Monday and Tuesday’s action, which adds to its significance. Since these one and two bar formations are expected to have an effect for between 5-10 days this should mean that the downside breakout in Chart 5 will turn out to be valid.

Chart 5

Chart 6

Keep watching those credit spreads

Trends in confidence in the bond market typically lead those for equities. Confidence in this respect is assessed by comparing the performance of a higher quality debt security to a lower rated one. One of my favorites is the relationship between the Barclays 7-10-year Treasury ETF, the IEF, to the iBoxx High Yield ETF, the HYG. Chart 7 shows that this ratio often leads equities at key turning points. For example, the confidence ratio bottomed out ahead of the S&P in 2009 and subsequently peaked in 2010. The ratio started to decline in 2014 and has been declining ever since. This week it fell to a new low and has now decisively penetrated the red support trendline. That line is a pretty long one, so its penetration suggests that the ratio has much further to decline. If so, that can only spell trouble for equities and the economy.

Chart 7

What’s going on with interest rates?

The Fed is raising rates but not all credit market sectors are co-operating. For example, Chart 8 shows that the two-year yield, which is responsive to Fed actions, has broken above its resistance trendline. The breakout is precarious because the yield has fallen back to the extended trendline and its KST is bearish. If it now falls below the extended line that would mean the upside break was a whipsaw. False moves such as that, should it materialize, are typically followed by above average price moves. And that would mean an unexpected drop in short-term rates.

Chart 8

On the other hand, the 5-year series in Chart 9 has been going sideways. The weak action of the KST suggests that a test of the lower boundary of the trading range is now in order.

Chart 9

Finally for yields, we look at the 30-year yield, where we can see that it actually violated a key support trend line on Wednesday. That’s highly significant because it suggests that the long-end of the market is not buying into the idea that rates are likely headed higher. It also says that these same investors are more concerned with deflation than anything else and represents a vote against Fed rate rising policies.

Chart 10

Chart 11 shows what this means for prices and that’s a decisive upside breakout for the Barclays 20-year Trust, the TLT. Note also that the Pring Bond Net New High Indicator has also turned bullish. If bond yields are falling and prices are rising, perhaps shorter term maturities will follow suit?

Chart 11

Good luck and good charting,
Martin J. Pring

The views expressed in this article are those of the author and do not necessarily reflect the position or opinion of Pring Turner Capital Group or its affiliates.