What are Interest Rates Telling Us?

As we outlined in class yesterday, interest rates and the bond market have a great deal of predictive ability concerning future levels of economic activity. The simple yet very powerful model of interest rates you should use is:

interest rate = f(expected inflation, economic growth, monetary policy)

As I noted, inflation expectations and growth expectations are not necessarily independent of each other, so the time frame you are considering becomes relevant to seeing which matters more. You can use the TIP:TLT ratio in StockCharts.com as one proxy for expected inflation, while a preferable way is to calculate (and track through time) the TIPS spread (= nominal interest rate - TIP rate with same maturity). This is available daily (in real time) from Bloomberg.com. Here is a link to the web page to use for this. As of today (4/21/10), the 10-year US Treasury bond has a rate of 3.79%, while the 10-year Inflation Indexed Security (TIP) has a rate of 1.43%. So:

TIPS SPREAD = 3.79% - 1.43% = 2.36%

Historical data on this is available from the Federal Reserve Economic Data (FRED).

If you want to find a proxy for the level of economic activity and income, you can use consumer cyclicals ($CYC) in Stockcharts.com. Where is support for this? Resistance? Are there any leading indicators from technical analysis that can be of help in the short-term (ex: bullish or bearish divergences based on the RSI)? 

So, you should use the interest rate model above whenever you need to explain interest rate changes or to make interest rate forecasts. To do this, you will need to generate a forecast for each explanatory factor. Possibly, over the time period of your forecast, a factor that usually matters will not matter much. Or possibly, a factor that normally doesn't matter much will be influential. Remember: NOBODY KNOWS THE FUTURE (except CNBC, of course).

For those of you who have taken ECN 327 with me, you can expand the basic interest rate model substantially. Using general macroeconomic models such as the IS-LM and AD-AS, you can identify a fairly large set of factors that determine either economic growth (Ye in those models) or inflation (changes in Pe in the AD-AS model). Basically, those factors are the "other things" of the relevant curves.

Looking at a chart (click to enlarge) of the 10-year rate ($TNX), resistance at 4% becomes readily apparent (note: you must divide the number on the right axis by 10 to get the interest rate). Short-term support is at roughly 3.5%. Why has resistance held over the one-year period covered by this graph? Rates fell twice from 4% (a double top, by the way). What causes interest rates to decline? To answer this question, use the interest rate model.

Rates decline for some combination of declining expected inflation, less expected future growth, or monetary easing. Obviously, we can rule out monetary easing. That leaves us with declines in expected growth and inflation.

Will the 10-year re-test resistance or support? Again, use the interest rate model to answer this question. Anyone doing their forecast on interest rates will have to do this.

Read the relevant chapters in John Murphy's Intermarket Analysis to further help you with an understanding of this topic.

February's Employment Report

February's employment report was better than expected. Even though there was a loss of 36,000 jobs, weather factors had been fully expected to exacerbate the final number. More importantly, when weather-distorted values of employment such as February occur, the jobs number in the following month almost always shows a significant rise, as some of the weather-related loss is "made up." This is clearly the expectation going forward, that March will show a rise in employment (not just because of the addition of Census workers). The unemployment rate remained at 9.7 percent, also better than anticipated, leading some to conjecture that we have already. Gseen the peak unemployment rate (I am not convinced of this yet). Here is an article about the report, and two videos from CNBC about the employment report. The first is pre-report, the second occurred after the data were released. The bond market hated the employment news, selling off, as the 10-year bond rose 8 basis points (remember: when bond prices fall, interest rates rise).

Most of the time, when an employment number is released, the stock market tends to bounce around, as bulls and bears battle throughout the day. Generally, this leads to a small daily change for the market that day. This was not the case on Friday, as the market shot higher and sustained its momentum throughout the trading day. The result was a large candle, a large real body, and almost no shadow (tails). Here is the chart for Friday (click to enlarge). Note that resistance in terms of the RSI(9) remains above 60, but it is now slightly overbought. So, will we make it to the next resistance at 1150 without a short-term pullback? Check next week's economic releases and see if there are any major releases that can materially affect the stock market.

 I believe that the stock market sustained its earlier momentum as the day wore on because in addition to the jobs report, there was a report that consumer credit had risen, painting a potential picture of how a recovery will gain traction. Of course, time will tell if that perception turns out to be correct, but I believe the market is pricing this in.

There was a good video on CNBC that discusses sectors (a bit) and the interest rate to look at (2-year US Treasury) as a signal that the market will break out from its recent sideways action.

Finally, I didn't mention it in class Thursday, since I want to see who reads the blog postings, but our exam will be on Tuesday, March 16. So, dig in, do the assignment, and study for the upcoming exam.

GDP Surprise

Friday's GDP report, the preliminary look at Q4 economic performance, was surprising. The consensus was for about a 4 percent gain, but the number came in at 5.7 percent. This was an excellent example of how "good news" impacts interest rates: good news tends to cause higher interest rates, as we discussed in class the other day. Here is the link for an article discussing this.

Initially the stock market and interest rates rose as the results were released. By the end of the day, however, things had changed.  The chart (click to enlarge), which uses 60-minute OHLC bars, shows how the ten-year US Government bond reacted throughout Friday's trading. First thing to note, the actual interest rate is 1/10 of the value listed on the right scale. So, for example, 36 corresponds to 3.6, etc. Second, note how closing values exceeded opening values for the first two bars (hours). How could we figure that momentum might begin to shift? Look for upper tails, where the bulls were unable to support high levels, and by the end of the time period, bears had pushed values lower. After the second bar (hour), things turned around for the rest of the day, as close was below open each hour. By the last hour, there was essentially a "toss up," as open and close were almost identical.

Why did rates reverse on the "good news." Much of the overall GDP growth was the result of inventory effects (3.7% of the 5.7%), which will not persist in coming quarters.So, while this GDP number was a surprise and good news, interest rates, like asset markets in general, are forward looking. So the news in coming quarters might not necessarily be all that much better than what the markets had been anticipating prior to the GDP release. More data, primarily for this actual quarter, will be needed to move the direction of interest rates from where they were that day. Support, though, appears to be at 3.6 percent. Will this level hold? As the course progresses , I will show you how to use economic models to make an educated guess at questions like this.

November Employment Report

The November employment brought with it several surprises. First, and foremost, payroll employment fell by far less than just about anyone (including me) had predicted. While the consensus number was a decline of around 120,000, the actual number was a decline of just 11,000. In addition to this, decreases from the prior two months were revised to show less job loss. So, with the addition of Census workers early next year, it is very likely that we will see the employment change go positive -- either next month when the November data are revised or when we get January or February data.  Second, there was a nostalgic element to Friday's action in that the stock market actually rose along with the US dollar. When was the last time that happened? You should read about the employment report from MarketWatch.com and the Wall Street Journal.

The stock market liked the employment report very much. The Dow-Jones Average started out showing a gain of around 150, but as is so typical of employment release days, gave most of that back (this apparently works in both directions). At the end of the day, the Dow was up 23 points (for 0.2%). Interestingly, the NASDAQ was up by a greater percentage than the Dow, as its 21 point gain was almost 1 percent. Typically, when observing markets it is a good sign when the NASDAQ outperforms the Dow-Jones average. As this stock market "rally" was occurring, the bond market obviously hated what it saw, so a selloff resulted. As bond prices fell, the 10-year bond rate rose by a full 10 bp, a rather significant change. The US Dollar index rose by just over one point (1.07) to close at 75.8. So, enjoy this combination while you can -- a bullish report triggered stock market gains, a bond market sell off, a stronger US Dollar, and a drop in Gold price. That is the way things normally go, but haven't gone this semester as the result of the dollar carry trade.

Along with this favorable economic report, of course, comes all the myopic garbage that has come to characterize coverage by the financial media. Will the Fed now begin to raise rates very soon based on the new-found economic strength? Give me a break! Is the carry trade dead, based on Friday? Gee, we have one full day of that result, so it must be inevitable! I'll probably reserve judgment, though, until I hear from Jon and Kate, and check in with Tiger Woods. Here is the URL for an article with an intelligent discussion of the likelihood of Fed actions based on Friday's report.

The interesting question is how long the pattern of the inverse relationship between the dollar and US stock market has existed. It must seem to all of you that this has been around for a very long time, that this is the "norm." For extra credit due at the beginning of class on Tuesday, produce a chart using weekly data going back three years with the Dow-Jones average and the US Dollar index in the same chart, both as solid lines. Adding annotations, eliminating other elements of the graph like MA's, pinpoint when the current pattern began based on this chart.

So the question now becomes whether the dollar carry trade is dead or possibly dormant for a while. If this is conjecture turns out to be true, the US Dollar should begin to rally without threatening the positive momentum of the US stock market. We can use technical analysis along with economic theory to ascertain whether any short-term bottoming of the dollar is in the cards. Based on the RSI(9) from weekly data, there was a bullish divergence for $USD -- the RSI had been rising while the weekly $USD was recently falling. So, in the very short-term at least, some dollar strength is likely, especially since the RSI is nowhere near an overbought level. In fact, the weekly RSI(9) is at 40.5, which if you look back several months to April, is a resistance level for the RSI. If that resistance is broken, the dollar index could go to either 77 (its next resistance point  determined the usual way) or all the way to 80 based on a Fibbonnacci Retracement from March of 2009 until the most recent low. Stay tuned!

10-Year Bond Rates

If you look at the 10-year bond rate since the end of 2008, the economic free fall, until the present time, you see several interesting and informative behaviors. First, when the economy was in potentially serious condition in November and December of 2008, rates gapped down on several occasions. This means that bond price gapped up on those occasions. Second, if we apply Fibonacci analysis to the bottom in rates at the end of 2008 up to the present time, you see that Fibonacci has been very predictive for likely declines from the recent 10-year peak of around 4% in June of this year. The chart below shows this (click to enlarge). Remember that the values on the right axis are 10x the interest rate, so 36 is really 3.6.

The 61.8% retracement level (around 3.27%) has been touched on several occasions. Note that the rate has yet to fall to the 50% retracement point (at 3.04%). While we remain slightly above the 61.8 percent mark, note that the RSI is still above the oversold reading of 30, so it is quite possible that we will see another retest of the 61.8 percent level at 3.27%. The likelihood of this rests on, among other things, markets continuing to believe the message delivered by Fed Chair Bernanke the other day.

What we have been witnessing in the short-term, however, is a rising stock market with a strong bond market. So, stock prices have been rising while interest rates have been falling. This is not the typical pattern. Usually stock prices and interest rates move in the same direction. You should think about this to strengthen your understanding of the stock and bond markets. The "other thing" that is not equal is the words of the Fed Chair.

I have recently heard some "talking heads" discuss whether the bond market is a bubble at present, while others are hinting that rates have gotten very high, potentially a cause for worry. I have plotted the 10-year rate weekly over a very long time period. The chart shows this from the early 1990s (click to enlarge). The current 10-year rate is hardly excessive based on its history, which showed it to be around 8 percent in the early 1990s. Note the long-term downward sloping resistance line. Were we to move up to that line, the 10-year rate would have to rise to 4.75 percent, which is approximately the level it attained during the double top in 2006-2007 (note: that double top is what converted me to using technical analysis -- the technical analysis prediction of a declining rate from that double top ran counter to the "traditional economic wisdom" of the day which saw higher rates coming). How likely is it for the 10-year rate to rest resistance at around 4.75 percent? Use the model of interest rates we have developed and enhanced from class:

r = f(expected inflation, autonomous spending components, monetary policy)

Remember: in place of economic growth in this model, you should now employ the Basic Keynesian Model which identifies factors that generate growth: changes in autonomous spending (from C, Ip, G, and NX). The resulting forecast will allow you to move well beyond the limits of technical analysis.

Friday's Employment Report

I had stated in class that the bond market anticipated a bad employment report. THE BOND MARKET WAS CORRECT. In anticipation of a larger-than-expected fall in employment (an actual fall of 263,000 -- much worse than the "consensus" estimate), and thus slower growth ahead, interest rates had been falling during this week. And, the actual number didn't do anything to reverse that trend. Here is a very short summary of the day's 10-year bond performance.


The chart (click to enlarge) shows the ten-year bond rate ($TNX). NOTE: the rate of interest is the listed value on the right axis divided by 10. So, 35 corresponds to a 3.5% rate, etc.  Resistance for the 10-year bond rate has recently been 3.5% -- you can see the rate bouncing off this level several times since August. Focusing only on this past week, we see a noticeable decline in the 10-year rate, in anticipation of a weak employment report.

As interest rates and bond prices are inversely related, note from the RSI indicator above the chart that rates are oversold, so a bond rally (on potentially bad news) has caused bond prices to be overbought.

There is one interesting thing about Friday after the employment release: the 10-year rate rose (and prices fell). And, while the rate hit 3.1% at one point during the day, the close was higher than the open. There was also a lower tail (remember: a possible signal of change of momentum). It is quite possible that the low on Friday may be a 10-year low for the short-term based on Friday's price bar. Keep in mind, though, that mortgage rates tend to be highly correlated with the 10-year bond rate, so it appears that we are going to see lower mortgage rates ahead (below 5% on 30-year mortgages). The real question is whether mortgage applications rise or fall ("other things" are not necessarily equal).

The stock market had a rough couple of days. After class on Thursday, the market dropped sharply. Friday, after the report, another sharp drop occurred until around mid-day when we came off the lows of the day. Here is a story about the stock and bond markets. For extra credit, due at the beginning of class on Tuesday, create a chart of the S&P 500 (daily) using "fill the chart" as the data range. Put the RSI in the same chart (not above or below it), paste this into a Word document. In that document, provide a brief summary indicating how the RSI signaled the recent stock market decline.

You should continue following the bond market throughout the remainder of this semester and beyond, noting what it is forecasting and contrast this with what the stock market is assuming. We will cover the stock market this week.