Bond History Doesn’t Apply Coming Off The Zero Bound

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My strongest philosophical market belief is that the rate of change is more important than the magnitude. This should not be a very controversial notion. This is why we spend so much time analyzing percentage gains and other forms of momentum over time. Whether a company’s sales are increasing or decreasing is generally more meaningful in the direction of the stock than the nominal amount of revenue. It typically does not change by orders of magnitude in the short run, so the speed of sales growth or decline often determines how a stock performs in both the short and extended intermediate timeframes.

Similar conversations happen when bonds start selling. The question is: Which is more important, the level of the 10-year yield, or the rate at which it is climbing? The most correct answer is: Both / Depends. But in assessing the reaction of the stock market this past year, the answer clearly appears to be the rate at which it is going up or down. 1.7% on 10-year isn’t a big deal when it’s been sitting there for a week — it’s a big deal when it races back and breaks into one of the fastest Treasury selloffs in recent history.

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We’re now looking at a version of this discussion around the tough road ahead for the Federal Reserve. Many argue that since interest rates are still so low, hiking will not derail the peace in riskier assets. I’m in the opposite camp: because rates are so low, each increase from the zero threshold is a huge change relative to the interest rate level, so the rate of change is quite dramatic. Likewise, the speed of the hike will be more important than the number of increases, and most important is the fact that this Fed tightening in general represents a 180-degree directional change from the last decade.

A major difference between now and the last time the Fed tried to raise rates (in late 2018) is that the Fed was employed to create a permanent inflationary force to prevent any sudden reversals from lowering rates. The situation today has a lot of potential. With 10.5 million job openings and a government ready to support the American worker, the most important, lasting inflationary force is just waking up: wage growth.

Investors spent the past week debating how serious Jerome Powell is about tightening up. Will he really just sell the properties instead of buying them at a slower rate? Would he do this while hiking? So many times? These are all interesting and important topics to explore, but secondary to one simple fact: The Fed went one way for a decade, and now it’s going the other.

The historical correlation between interest rates and stocks is positive: the two generally move together as economic forces drive them higher. This does not apply today. Rates exiting zero bound and stocks starting at record valuations make historical comparisons mostly useless. We are seeing this already, with 10-year yields now trending higher during tapering; The last two tapers reduced yields.

We went through a pandemic, recession, and interest rates never had to be as negative as many predicted. The rates are down to zero, and the rate of change from zero is mathematically horrific and unprecedented. This means that the turbulence we have been getting last month is now the trend. Look for the lower-low and lower-high on the Nasdaq
NDAQ
To confirm it soon.

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