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The Critical Connection Between Confidence in the Federal Reserve and US Interest Rates

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Remember, mood drives changes in laws, not the other way around.

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Coming together as they did, I believe that the confidence embedded in these five long-term and short-term variables formed the peak in bond prices last summer. Everything that could be a tailwind was.

While I am sure there are other factors that you may want to add to the list, and/or that you may want to reweight the factors as to their relative importance, I think that what happens now with regards to these five factors will drive the future of interest rates.

As I noted above, in the past year, we have already seen signs of deteriorating confidence in the Federal Reserve. For some time, I have cautioned that the bankruptcies of GM (NYSE:GM) and Chrysler would matter as far as creditors' rights. Now Detroit, Michigan, and Richmond, California, are raising even more questions. Needless to say, what happens next will frame America's relative positioning among global investors.

Remember, mood drives changes in laws, not the other way around. As I noted above, near the peak in confidence, consumer bankruptcy laws were changed to favor creditors. With falling mood, the pendulum will shift to the other direction. Just consider the changes made to "loosen" student loan default practices over the past two years.

I believe that all five of the tailwinds described above have already turned to headwinds. But please appreciate how much confidence and trust were implicit in each one. Confidence takes a long time to form but just moments to destroy. While it took thirty-one years for 10-year US Treasury yields to fall from 16% to 1.4%, I expect that the speed of the rate rise will be jaw-dropping.

Confidence in bonds is fading -- and if you think investor confidence in equities matters, multiply that geometrically, if not exponentially, for bonds. Bonds are the ultimate confidence game. If there were ever a shorthand story for bond investors, it would be "bonds = safe." As we saw in Europe, if that is no longer true, it is game over.

Today bond investors believe that the rise in rates is a function of the taper and an improving economy. So long as that story holds true, the rise in rates will be contained.

I don't believe that story. To these eyes, the story in fixed income is falling demand -- and it is the only story that matters. I would pay extremely close attention to the five variables listed above. As they go, so go rates and the US economy.

Peter Atwater's groundbreaking book "Moods and Markets" is now available on Amazon and Barnes & Noble.

"Peter Atwater brilliantly provides a framework for understanding both the socioeconomic hubris that led to the great credit bubble of the past decade and the dark social-psychological hangover that has resulted from its collapse. In so doing, he offers an invaluable guide to what promises to be a very difficult and turbulent period ahead as we experience what he calls the 'me, here, and now' behavioral tendencies of the post-crash world." -Sherle R. Schwenninger, Director, Economic Growth Program, New America Foundation


Twitter: @Peter_Atwater
Position in SH and JPM.
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