Look Up Not Down: This Time For Interest Rates

• Two reliable indicators point to a new bull market in interest rates
• What are the short-term technicals saying about rates?
• High versus low beta

Two reliable indicators point to a new bull market in interest rates

Last week I wrote that the vast majority of long-term stock market indicators were bullish, but that the short-term ones were bearish. My conclusion, was that since the major trend is positive, we should look up not down because that’s the direction in which surprises would likely develop. This week’s webinar (see the charts here) made the case for higher interest rates. Not because of the typical trend reversal evidence as that does not exist at present. The argument was based more on mean reversion possibilities because yields have definitely moved to an extreme on a very long-term basis. Again, we should probably be looking up rather than down.

Take Chart 1 for instance. It compares the 20-year government yield ($UST20Y) to its 52-week ROC. Historically, when the ROC has fallen to or beyond the -25% level and reversed back through it, this has represented a reliable indication that yields are tired of falling and are now ready to rise. The red arrows in Chart 1 flag situations where the ROC has moved above the +25% zone and reversed back below it. Those signals have also represented reliable indications of a forthcoming primary trend drop in rates. It’s similar to the pendulum of a clock, as the ROC swings from one extreme to another. Occasionally it misses the +/- 20% extreme, but whenever it reverses from such levels, so usually does the yield. Altogether I count 13 valid signals, with no losers. Note I am counting the 1999 and 2014 “double” signals as one. Even so, I like those odds.

Chart 1

Chart 2 comes at the problem from a different point of view. This time, we use sentiment in the bond market to forecast yields. In this case, the sentiment is reflected by the momentum (KST) of the ratio between high and lower quality bonds. There are many ways of calculating these bond market confidence relationships, but I usually use the ratio between the 20-year government and Moody’s Baa corporate yield as its history goes back to 1919. When this momentum bottoms and reverses to the upside, it indicates that bond investors are growing in confidence. That’s because they have begun to replace their fear of credit defaults with optimism concerning the economy. When the economy turns up, credit demands expand and the price of credit, aka interest rates, starts to rally. You can see this by the fact that the green arrows flag the momentum lows and the yield action to the right of the arrow tips generally point north. It seems as though it’s started to turn, but I can’t quite call it decisive yet.

Chart 2

One ratio you might want to watch is that between the iBoxx High Yield to the Barclays 20-year Trust (HYG/TLT). This data, unlike the Corporate Baa series, is carried by StockCharts, which means that you can follow it on a daily basis. Just remember to put the _(underscore) character in front of the symbols to avoid including dividends in the calculation. Chart 3 indicates that the ratio is already marginally above its down trendline. However, I would like to see it move above that .66 level which is just above the red trend line. We want to make quite sure that the trend has reversed to the upside. A move above .66 would also take out the spring high and clear the 200-day MA. Note that the thick arrows roughly correspond to movements in the long-term KST, an indicator that looks set to go bullish at any time.

Chart 3

If we use a shorter maturity ETF, such as the 7-10-year Trust (IEF), you can see that a clear breakout in Chart 4 has already taken place. In addition, both KSTs are in a bullish mode. That strongly suggests that it’s only a matter of time until the HYG/TLT relationship follows suit.

Chart 4

What are the short-term technicals saying about rates?

Friday experienced several strong outside bars for many interest rate series. Outside, in this case, hints at higher rates and lower prices. Chart 5 for instance, shows the iShares 7-10-year Treasury ETF, the IEF. In order to make the chart consistent with the direction of rates, I have plotted this series inversely. You can see that the outside bar broke and closed above both converging trendlines but during this week’s action was unable to hold above them. Right now Friday looks as if it will turn out to be a false upside break for yields. However, the Friday intraday low and the red up trendline are still intact. Also, the PPO remains in a gentle uptrend. From a short-term perspective Friday’s high and low take on some importance. A drop that holds below the low would confirm the false upside break and most probably reverse the upward trajectory of the PPO. On the other hand, a move above Friday’s high would re-confirm the outside day and result in a break above the two converging trendlines. It would also be significant in the fact that it would validate the bullish (yield) picture being painted by the indicators in Charts 1 and 2. Perhaps we are going to have to wait for this Friday’s Employment Report for guidance?

Chart 5

REITs versus Financials

As a general rule, REITs prefer falling interest rates as their high yields attract buyers. On the other hand, when rates are rising, the last few years have seen investors preference for financials as rising rates enable these companies to raise fees and experience higher margins.

Chart 6 demonstrates this by comparing the 10-year yield to the ratio between financials and REITs. This relationship is not perfect, but you can see that a rising ratio is generally associated with rising yields and vice versa. One important note is that REITS are currently included in the financial sector by S&P, so there is a bit of historical double counting. However, this will end in September as REITS will be removed as a financial component and will stand independently on their own. In any event, the point I am trying to make is that if the rising rate scenario comes to pass, then financials would likely outperform REITs.

Chart 6

High versus low beta

Chart 7 compares a couple of relatively new ETF’s, the S&P high Beta and the S&P High Quality (SPHB/SPHQ). It seems as though the high beta series has broken out against high quality. That suggests that a new, more speculative phase of the equity bull market, has begun. The long-term KST of this relationship is not quite bullish, but the recent breakouts suggest that downside momentum has dissipated and that this relationship, favoring more risky entities, will continue to advance.

Chart 7

When I first looked at this ratio it occurred to me that it was very similar to a similar one for bonds (HYG/TLT). Sure enough, Chart 8 shows that there is a definite connection between the two. In this respect, the green shadings approximate when both series are rising, and white when falling. At this point, both are signaling a trend of growing confidence. That seems to be a great place for ending this article.

Chart 8

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.