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The Danger of Rising Rates

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The following alert was sent to subscribers of Peter's Fixed Income Report yesterday.

Rising Rates are Bad

The market has been begging for some great rotation out of bonds and into stocks.  They may be getting part of what they wished for – the rotation out of bonds.  The problem is that “bonds” are too broad of a term.  We are seeing “risky” bonds weaken, whether the risk is duration risk or credit risk those markets are weak.

What is far less clear (so far) is where that money is going to.  This belief that investors will view equities rather than money market instruments as a safe haven seems to rely on some dangerous assumptions – mostly that investors are dumb.

Mortgage Rates are the Biggest Risk

In virtually every bull case there is some mention of the housing recovery.  While we have seen an okay, not great housing market, we are very concerned about the impact of rising rates on housing and therefore the economy. 30 Year Mortgage (National Average)

Rates have spiked 66 bps since May 1st and don’t yet reflect yesterday’s sell-off in the 10 year and certainly don’t include this morning’s weakness.  We are should see a new high at this stage, on that is at least 80 bps more than the May 1st level and one that threatens to be the highest rate in at least 2 years.

An increase from 3.4% to 4.2% on a mortgage on an “average” home price of $242,600 is a little over $100 a month difference.  With little to no wage growth, how is that going to help?

It would be one thing if the bond market was selling off because growth was so good and the economy was cranking out high paying jobs at a fast pace, but it isn’t.  Bonds are selling off because the market has become confused what to do about QE and selling bonds seems to make sense on the back of tapering (ignoring other sources of buying and diminishing supply). So with bonds, particularly the 10 year treasury, selling off we are seeing a change in mortgage rates unlike any that we have seen in the past few years.

We think that this spike in rates may nip the nascent housing recovery in the bud.

High Yield and Emerging Markets Pose are Next Most Dangerous

The high yield market has been selling off more or less for 2 weeks now.  The emerging market bond situation has been even worse.  Remember Spain and Italy? Well someone does.

Spanish 10 year bond yields

Since many of you are probably sick of seeing graphs of high yield and emerging markets, let’s start with the Spanish 10 year bond.  While the economic situation there has gotten worse if anything, super Mario had managed to distract all attention from the situation.

Now with the German courts once again looking at the activities of the EU and its various entities, the risk is specifically coming back to haunt Spain and Italy, though they are also getting caught up in the wholesale selling of risky bonds.
Spain is right back to the low 4.7% yield that had been an inflection point.  If it breaks through that the next real level that the market battled around was 5.1%.

With no actual OMT and lots of “carry traders” long these bonds on a leveraged basis, there is room for some serious selling pressure, in what is a vacuum of liquidity.

HYG Trading

HYG and other high yield etf’s and the market itself were able to bounce nicely from Thursday’s lows to a nice post NFP high.  While stocks were able to continue to rally, the high yield ETF’s reached the epitome of their glory at 10 am and have struggled ever since and should have an ugly opening this morning.

I can’t overstate how dangerous we think the ETF spiral is to this market.  I think that the vicious cycle of selling and arbitrage will kick back in dragging us to new lows.

But what does this have to do with stocks or the economy?  It actually has a lot to do with the economy and the market.  It might not be quite as obvious as what is occurring in the mortgage market, but the impact is no less meaningful.

Higher Costs for Issuers

Borrowers will be paying more.  Municipalities, sovereigns, and companies will all be paying more for their debt.  This is relatively minor at this stage as so many have satisfied their issuance needs but is a risk.

The bigger risk is that some companies might not be able to get financing at all.  High yield and the leveraged loan space are funny animals.  During good times it seems like even I could issue a royalty bond and get good terms, but during bad times, it can be hard for even a good issuer to get money, and right now there are a number of weak issuers.

Investors start getting nervous in these markets.  As prices drop it is hard to avoid thinking about just how bad some of the issuers are.  Highly leveraged companies that have been carried along by an okay economy and an aggressive Fed.  It is hard not to wonder “what if” something goes wrong, how will these companies do? 
So the bigger risk is that some companies will get priced out of the market.  That would have a far more immediate impact than the increasing cost to borrow, but neither is the real problem.

There Goes the Relative Value Story

Just as the Treasury sell-off forced investment grade bond yields to increase, which in turn caused high quality longer duration junk bonds to weaken, which caused selling in the weaker less liquid high bonds, we think the next step can be stocks.

Confusing Graph of SPY dividend yield versus 10 Year treasury ETF dividend

I am sure if there are better ways to “smooth” the data especially since late last year included so many special dividends ahead of the “cliff” but the story is about the same.  At one point the yield on stocks seemed very high relative to bonds.  Stocks looked cheap or bonds looked rich.  We have seen a divergence in the past couple of months as stock gains have outpaced dividend increases (lowering the S&P yield) while treasuries are at new highs in terms of yield.  That differential doesn’t support equities in the way it once did.

With so many investors piling into “dividend stocks” and “dividend ETF's” we see a real potential for the cascading “yield sell-off” to move into dividend stocks and may yet see a spiral effect there as well.

The Bottom Line?

Higher yields are bad and will put pressure on the market.  What remains to be seen is whether once this cycle has started if it will be stopped by any treasury strength or once it has started it is too late and we can resume full on “risk off” trading which is our Bond Bubble Paradox.
POSITION:  No positions in stocks mentioned.