In this note on March 16, 2023 (March 15, U.S. time), I suggested that shorter-term interest rates would start to rise when the Copper/Gold Ratio trades 2.5 standard deviations below its weekly mean and implies a poor moment of timing for those buying bonds.
Brazil commenced raising interest rates in the 1st quarter of 2021. The central bank rate climbed from 2% to 13.75% which represents a 6-fold increase.
Brazil conducted 12 rate hikes.
The U.S. commenced hiking rates 12 months later year later, in the 1st quarter of 2022. The fed funds rate have risen by a factor of 9 (from 0.5% to 5%).
The U.S. has raised interest rates 9 consecutive times.
Brazilian’s carry a Household Debt to GDP ratio of 34%.
The Americans have 75%
Aussies are sitting on at 114%
The chart below shows the Brazilian 10 year bond yield compared to the Brazilian inflation rate.
Brazil addressed their rate hikes much earlier and when coupled with the halving of many commodity prices since their 2022 peak) has seen the Brazilian inflation fall from 12% to 5.6%
I think that interest rates moderate in the coming months back to a ‘normalised’ level from which to work from, into the next cycle.
To position for this thesis, I could buy bonds, a bond ETF, treasury futures……
I’m thinking of expressing this (investment) view by looking at companies who provide automobile loans.
Perhaps those who are focused on sub or near prime credit risks?
Auto loans become more expensive as rates rise. Cars (new and used) are more expensive. Vehicle ownership is still desired.
But getting exposure to this idea through bank and credit unions is lost amongst their other business lines.
I’ll dig through a company such as Open Lending (LPRO.US). They help lenders in assessing risk to car loan applicants.
My interest was piqued when I overlaid the price chart of LPRO against the U.S. 2 year bond yield. High interest rates is bad for Open Lending’s business. What if the opposite occurred?
Due to secular underinvestment and the resulting tightness in various industries, I think inflation will stay at levels higher than we’ve been accustomed over the past 25 years.
This is the ‘new’ calculation and consideration for the next decade or so.
However, in the nearer term, I do think they will abate from the current levels of 7%, 8% or 9% being seen today.
If I’m pressed for a figure, let’s say 4% or 5%.
If pundits could cite and prove today’s inflation rate is a result of the rising prices seen across a host of commodities, shelter, groceries, services, etc……why are we (collectively) not acknowledging that falling prices may temper inflation?
Keep in mind that official inflation rates report the prices seen yesterday.
I have collated various charts showing prices rising and since falling.
Remember all of that palaver about soaring Lumber and Steel prices?
Take a look at them now.
This is part of my argument that inflation has ‘peaked’ and so have government bond yields.
I mean, I think we are in the last decile or so.
Other parts of my argument for lower prices in various assets/commodities and a subsequent abatement of inflation has been a combination of my long-term mean reversion thesis along with my written notes about the factor and velocity of interest rate hikes.
The last holdout in price declines remains in various energy prices such as Diesel and Heating Oil.
Interestingly, Crude Oil prices have only fallen 30% from their peak, they are now trading at prices last seen in 2011 – 2013, when U.S. inflation, at that time was being reported between 1.5% – 3%.
Back then, we weren’t making an overall ‘hoo-ha’ that inflation was about to scream higher.
Obviously there is more to this analysis and many variables from renewed supply chain disruptions coupled with continued tighter labour markets and pent-up demand when China fully reemerges from COVID lock-down could thwart this thesis.
Not assigning reasonable probability that these falling prices may/will contribute to lower inflation reports in coming quarters is something that may catch investors or the market, out.
The result of abating inflation will have an affect on suffering longer duration assets, the strong U.S. Dollar and interest rates, which have risen between 11-14 fold from their mid-2020 lows.
Once (if) that happens, then we move onto figuring out where inflation and prices move to from that moment.
Checking in on the Copper/Gold Ratio and if it is Oversold on a Weekly basis because its coincides with a “low” in the S&P 500.
We saw the most recently occurrence in June 2022.
We can also look at the Copper/Gold Ratio as an indicator of the economy’s health.
A glass half-full suggests the economy currently isn’t ‘too sick’
A glass half-empty view ponders that the economy is heading into sickness.
There is no written rule that the Copper/Gold Ratio needs to ‘double dip’ into Oversold territory again. It may already have done its ‘sickness’ signalling and we haven’t seen it make such a double dip before.
Would would it take to do so?
One scenario would be to see the Copper price trade to $3.00 (12% lower than today) while the price of Gold remains steady.
My studies suggest this is plausible while Copper’s medium term trend remains downward.
It’s worthy to note that the Copper/Gold Ratio (HG/GC) correlates well with the direction of interest rates and currently there is a notable divergence occurring, with U.S. 10 year bond yields drifting higher and apart from the HG/GC.
I keep reiterating that what is more important about where interest rates have traded up to isn’t about the nominal rate, but rather the quantum or factor which the nominal rate have risen by.
Yes, the numbers look bigger when rates are rising from 0.5%…..but people, households, companies, governments etc etc don’t necessarily temper their borrowing when rates are low…..We tend to become accustomed to the ‘going rate’.
In general, the piggies are always at the trough.
When a family is seeking a mortgage of $600,000 but their credit provider announces the good news that they have been approved for $680,000, I suspect that they accept all of the $680,000. After all, they can use it for the landscaping etc etc.
We are happy to continue taking as much we can get or is available.
If my mobile phone plan allows for 20GB of data, I’m sure I’ll use it up and then ask for an upgrade to 40GB. Soon after, I’ll be requesting for an upgrade to 60GB of data.
When the Australian cash rates were 0.25% in last 2020, I was asked if I thought the Reserve Bank of Australia would cut rates at the next meeting.
My response was, “who cares”. The questioners were often shocked by my seeming flippancy.
At this point, I would add by asking, “How much debt do you have and how pressure are you under, that you need a further 15 or 25 basis points of relief”.
Today, if your cost of borrowing has risen from 3% to 6% and you are now speculating whether interest rates go up a further 1% receives the same response from me with the difference being, are you still carrying so much debt that you may ‘break’.
Is it the Fed that is possibly going to ‘break something’ or have we simply kept taking on more debt?
In the graphics below, you can see where the citizens of various nations sit in the indebted stakes.
Look at those frugal and financial responsible Latvians and Hungarians.
Household Debt as % of net disposable income source: OECD
Let me get back to the illustrating the ‘factor’ of the rise.
When rates went from 6% to 8%, it was only a 33% increase.
When rates went from 8% to 16%, it was ONLY a 50% increase.
Mortgage rates in Australia have nearly doubled. In the U.S., they have easily doubled.
The U.S. 2 years Treasury Bond yield has risen 10 fold.
When your interest repayments or the total cost of capital increase by such a factor, it is the quantum of the rise from the previous levels where you were comfortable with, that hurts the most.
My studies show that government bond yields have never risen by factors of 3 or 4 from their lows within any credit cycle.
At these extremes, as the chart within the below shows, the 2 year bond yield is miles above its 200 week moving average.
Why doesn’t mean reversion matter now, when it has many times prior?
Expecting rates to go higher and challenge gravity, probability and mathematics is a very foolish and crowded trade.
This is not about calling doom and whether the Fed ‘breaks something’……but rather it’s about thinking independently and reading the market tape as it is.
Behind the talk of where rates go to, sits speculative or investing opportunity.
If you have a view….then make the trade and take a position.
Those who shorted bonds when rates were 1% have made a fortune.
Today, if you think rates go up noticeably more……enough to tempt you into a trade, then short bonds and ride the expectation of whether the Fed keeps hiking rates to a point where ’they break something’.
If you think interest rates will fall, you could buy bonds.
Although, this is not a binary choice and the bond market may not be your natural business.
You can express you trade idea in many different manners.
For example, if interest rates keep rising, then you could short the equity of heavily indebted companies or technology stocks which aren’t profitable and have negative free cash flow, or
If you think rates are going to decline, then perhaps owing shares in high growth companies may see their prices ‘catch a bid’.
Of course, this is not personal advice and it’s important to do your research and analysis.
I don’t know why people make it so difficult for themselves.
The bond market is ‘more correct’ than the rhetoric or ‘tough talk’ that central bankers provide.
The former isn’t emotional while the latter is and susceptible to biases.
The U.S. 2 year bond yield started rising and forecasting higher interest rates in October 2021, when it passed the 0.30% level.
By the time the Federal Reserve announced its first rate hike on March 17th, 2022, the U.S. 2 year bond yield was 2.20%
I think it is a waste of time speculating or debating if the Fed will ‘pivot’ and change direction.
Firstly, a reversal of current direction is not an automatic occurrence. The Fed can keep rates where they are for a little more.
Secondly and more importantly, the bond market will tell you more.
Currently, 2 year bonds are yielding 4.15%.
Much is priced in and now poised at stretched levels.
The chart below shows the Fed raising rates by a factor of 12 from the 0.25% low.
This is in belated sync with the 11 to 13 fold hikes seen in many other economies while those commodity sensitive nations (where the citizens are least indebted compared to those in the G10) such as Brazil, Chile and Mexico all started hiking rates (trying to fight inflation) between March 2021 and June 2021.
The most crowded trade, thesis and belief is still – for higher rates.
Not many are calling lower rates.
I am.
For various reasons, I think this U.S. 2 year bond yield falls back to the 2.30%-2.60% range in the coming 10-20 months.
Does this mean that the Fed cuts rates into the next year?
Perhaps, Yes. Maybe taking the Fed Funds Rate to 2.75%
But I can’t see how they can raise rates another 1% with out ‘breaking something’.
U.S. year bond yields have never seen 8 consecutive weeks of rising yields. Stocks and Commodities tend to see streaks lose steam in the 7th or 8th consecutive week.
We are closer to the streak ending.
The U.S. 10 year bond yield has never been Overbought on a Monthly basis, until now.
The U.S. 10 year bond yield has never been extended this many percentage points above its 50 month moving average.
The U.S. 10 year bond yield is near to trading up to 2.5 standard deviations above its rolling monthly mean for only the 5th instance in 40 years.
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