Interest Rates are the Temperature of the Economy

Interest rates are on the raise, up nearly 9% since June 1 and just under 10% year-to-date.  Is that good or bad for the stock market?

Think of interest rates in terms of the body’s temperature.  A “normal” human body temperature is around 98.6 degrees Fahrenheit.  Higher than that and it’s likely there’s an infection or inflammation; a lower body temperature may be a sign of diabetes or thyroid problems.

So an elevated temperature isn’t necessarily a bad thing, it could be an indication of a healthy body fighting off a virus.

Likewise, high/low interest rates may be the sign of a healthy economy fighting off inflation or recession.

A “healthy” 10 year Treasury yield is generally thought of as near equal to nominal GDP.  Sustainable real GDP growth of over 3% and tame inflation under 2% would equate to a theoretical 10 year yield in the range of 4-5%.

Note the below Long Term Trend chart, interest rates were in the 4% range in the early 60’s and coming out of the 2000 Dotcom Bubble.

Starting in the mid-60’s, interest rates began a 20 year climb to compensate for runaway inflation (like a high temperature fighting an infection).  The cycle retraced during the next 20 years as inflation was sequestered, and the economy benefited from the end of the Cold War (reduced military spending and technological expansion from growth in computing, communications, and the liberation of the internet).

Rates continued to fall to historic lows for the following decade in reaction to the bursting of the Dotcom Bubble, 911 Terrorist attacks, and the collapse of the Housing Bubble in ’08…in an effort to stimulate the metabolism of an anemic economy.

Since the Great Recession there have been many premature forecasts that rates would “normalize” to around 4%.  The question at hand is whether the recent increase in yields will continue or stall somewhere short of 3%?  Like the body’s temperature, it will depends on the “health” of the economy.

The below Short Term Trend chart shows yields forming the right side of a recovery base.  Current support levels are well above the lows of 2012 (near 1.5%) and it will be a very bullish sign (for increasing rates) if the 50 day moving average (red line) crosses above the 200 day moving average (green line).  This is referred to as a “Golden Cross” because it often foreshadows an uptrend.

The real test of the economy’s strength to support higher interest rates will be if resistance can be breached at 2.5-3.0%.  I personally think it’s unlikely.  GDP remains feeble.  (The IMF recently downgraded US 2015 GDP to 2.5%.  This is the 7th year of false hopes for the economy to “reach escape velocity”.)

I believe the greatest threat to a pullback in the stock market isn’t higher interest rates but the lack of productivity growth.  Perhaps lower energy costs can compensate for poor productivity.  We’ll have to wait and see.

Long Term Yields 150609

Short Term Yields 150609

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