You Need to Take an Interest in Rates

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What a week we have had.

Literal and figurative bombs are going off all over the world.

Kim Jong-un is stirring the pot with the detonation of a H bomb. I think he just loves getting up the nose of the west with his unpredictable behaviour. Not to mention that haircut of his.

The always simmering Middle East tensions have bubbled over (again) with the Saudi’s execution of Shiite cleric Nimr al-Nimr.

Oil has bombed to a 12 year low. What kind of havoc is this causing with indebted US fracking businesses?

Citi group issued a warning about the recent rally in the iron price. They think it could be short lived. With Roy Hill, Rio and Vale all bringing more supply to the market in the coming year the prediction is for the ore price to fall back into the US$30 range or possibly lower. Iron ore miner Grange Resources issued a statement flagging the possibility of redundancies. This isn’t the only mining company running the ruler over their costs.

China’s share market tanked not once but twice and on both occasions ‘time out’ was abruptly called. Fat lot of good these so-called market circuit breakers do. Get it over and done with rather than prolonging the process, I say. The reality is, markets — like water — find their own level…whether that happens quickly or slowly.

The US markets are playing follow the Chinese leader. Although they are a step or two behind the pace being set in Shanghai.

According to Yousef Abbasi, a market strategist at JonesTrading Institutional Services in New York, ‘China devaluing its currency sparks concern that the global growth engine is starting to slow and that creates a dump of any high-flying stocks or anything people perceive as risk,

Makes me laugh when I see China described as ‘the global growth engine. We know from last year’s McKinsey report that China quadrupled its debt level from US$7 trillion to US$28 trillion between 2008 and 2014. Any household, business or nation that goes on a debt bender can create ‘growth’ but it ain’t real or lasting.

China has reached peak debt — at least for now. The ‘growth engine’is stalling. Not a hard concept to grasp.

As usual the Aussie market is playing a support role and does whatever Wall Street tells it to do. We are barely hanging onto the psychologically important 5000 point level.

Do you realise the All Ords first went through the 5000 point mark in March 2006…a decade ago? Hang on I hear you say ‘aren’t share markets supposed to go up in the long term?’

Only if you believe investment industry spin.

A massive credit crisis exposing assets to the greatest fire sale in history. That’s the direction the next decade is going in. If I’m right, we may see the All Ords still struggling to make a sustainable breach above the 5000 point level in another 10 years’ time. Ouch.

This week the Baltic Dry Index (a measure of the cost of shipping commodities around the world) hit a record low.

‘Holy ship Batman, what does this mean?’

‘Economics 101 Robin — there’s more ships than there is stuff to put in these ships so transportation costs fall…and hard’.

Away from all the headline grabbing action, the spread (interest rate differential) between US treasuries (perceived as risk free) and junk bonds continues to widen.

Source: FRED

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Expansion and contraction of the interest rate spread coincides with periods of heightened anxiety or complacency.

The tick up in 1998 was due to the collapse of Long Term Capital Management (LTCM) and the prospect of this failure would bring down Wall Street. Once that crisis was averted, rates settled a little.

The next three spikes in rates occurred when the dotcom bubble burst, followed by 9/11 and then the lead up to the invasion of Iraq.

As these events faded into the background and the US housing bubble created the illusion of prosperity, complacency returned. Investors were happy to accept a measly 2.5% extra interest to lend money to companies with dubious credit ratings.

When that period of stupidity imploded so spectacularly in 2008/09, investors suddenly demanded a 20% margin above the risk free rate. Panic was in the air and investors (those still with cash) wanted to be rewarded handsomely for the risk.

QE and zero interest rates bought an uneasy calm. The panic subsided. Then the first Greek crisis in 2011 sent the interest rate spread north.

The declaration of ‘doing whatever it takes’ was the sedative needed to settle investor nerves. The concerted effort of central bankers lulled investors into a state of deep complacency.

They were happy to lend money to dodgy businesses in return for a lousy 3.5% above the US treasury rate.

This meant investors were prepared to risk some or all of their capital for a paltry reward of 3.5%. When this is all over and those debts are worth cents in the dollar, that’s going to prove to be the dumbest decision interest hungry investors could have made.

Since mid-2014 the spread has been steadily rising. The smart money is starting to smell risk in the air.

Events of the past week have pushed the margin being demanded to 7.5%. Investors are after a little more compensation these days.

What we’re seeing in this graph are the seeds of nervousness being sown. As the global economy continues to offer up evidence of the fraudulent post-GFC recovery, we’ll see this nervousness morph into a heightened level of worry followed by wholesale panic.

Personally I don’t think an additional 7.5% return above the US treasury rate is adequate compensation. Not to offset the potential risk of losing most of your capital.

Wait for the crisis to become full blown and then invest. Why? The margin could well be above the previous high of 20%. And any companies still standing are likely to be good for the money.

Unfortunately most people pile into this rubbish when the spreads are low and every dog of a company is dressed up to look like a beauty pageant entry.

Movements in market based interest rates provide you with an insight into investor moods.

Serious investors should maintain an interest in this indicator.

Regards,

Vern Gowdie

Editor, The Daily Reckoning

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Vern Gowdie

Vern Gowdie

Vern Gowdie has been involved in financial planning in Australia since 1986. In 1999, Personal Investor magazine ranked Vern as one of Australia’s Top 50 financial planners. His previous firm, Gowdie Financial Planning, was recognized in 2004, 2005, 2006 & 2007, by Independent Financial Adviser magazine as one of the top 5 financial planning firms in Australia. He is a feature contributing editor to The Daily Reckoning and is Founder and Chairman of the Gowdie Family Wealth advisory service and editor of the Gowdie Letter To follow Vern's financial world view more closely you can you can subscribe to The Daily Reckoning for free here.
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