In the last issue of this newsletter, I made an observation that the stock market was seemingly ignoring a rise in interest rates.

This week the market abruptly took notice.

The 10-year US Treasury this week accelerated higher moving from 3.05% on Tuesday to 3.23% at the close of business on Friday. This broke the previous 2018 high of 3.12% set in mid-May. To many technical analysts, this represents a break-out and signals higher rates to come.

The S&P 500 fell almost 40 points in two days.

It does appear that the path of rates seems to be upward. For almost 40 years interest rates made a long succession of lower lows. On July 2016, the 10-year yield was 1.30%. Now we seem to be making higher highs in rates.

How will bond investors behave?

It will be interesting to see how bond investors, if indeed rates will continue to rise, behave as their portfolio values decline.

Recall that bond prices and rates move inverse to one another. Higher rates mean lower bond values.

• The Vanguard Total Bond Index Fund lost about 1% this week and is down 2.65% this year.
• The Vanguard Long-term Bond Index Fund is down almost 8% year-to-date.

Market analysts used to talk about a “Great Rotation” meaning that when rates finally rise, investors will sell their bonds and buy stocks. I’m not hearing that anymore. I’m not sure why.

Perhaps the increase in short-term rates – the 3-month Treasury bill now yields 2.2% means that investors will sell their bonds and go to either short-term notes, CDs, or cash.

A growing consensus should always be examined carefully. Momentum moves opinions and subsequently prices, too far in one direction. The mantra is for higher rates.

The rest of the world seems to be slowing

While the US economy is running at a fine pace with GDP growth over 4% in the 2nd quarter, Europe seems to be slowing. Except for July, the European Purchasers Manager Index (PMI) has fallen in every month this year.

Like Europe, China’s PMI has moved lower throughout 2018. In general, the Emerging Markets are experiencing similar trends.

Can US growth continue at the same pace?

Can US growth continue at the same pace when the rest of the world seems to be slowing? If the answer is no, interest rates in the US may not rise as much as the growing consensus believes.

A lot of economic data is to come over the next few weeks. The inflation reports are due next week. If recent wage increases and higher gasoline and oil prices begin to flow through into the inflation indices, there will be more upward pressure on interest rates.

We have seen certain groups like FAANGs doing very well in 2018 while other sectors like Financials doing poorly. If interest rates continue to rise, we might see the performance gap between various sectors narrow.

I’ve mentioned before that low interest rates make suspect business models work. Easy money and low cost of funds help growth. Low rates also boost valuation multiples so that companies with low or no earnings can enjoy high stock prices.

Times may be changing…

— Ian Green, Pendragon Capital Management

Subscribe to Pendragon's Newsletter

Note: This blog article is intended for general informational purposes only. Nothing in it should be construed as, and may not be used in connection with, an offer to sell, or a solicitation of an offer to buy or hold, an interest in any security or investment product.