The last several weeks have been more interesting for bonds than many investors may really appreciate. Between the selling by the People’s Bank of China and the fluctuating expectations for the Federal Reserve to hike rates on Sept. 17, the bond market may set the tone for the end of the year.
The Fed will be hosting its bi-meeting press conference on Sept. 17, and futures traders are currently pricing in a 30% to 40% probability that the overnight target rate will be increased at that time.
Market volatility, however, has added to the uncertainty about what the Fed will do, so those estimates have fluctuated wildly over the last few weeks.
Bond Yields Under Pressure
Adding to current volatility is the fact that the PBOC has been selling U.S. treasury bonds to strengthen the Chinese yuan after the currency dropped more than expected.
The PBOC dropped more than $94 billion worth of U.S. bonds last month alone. We don’t have complete transparency into the PBOC’s actions, so the actual number may be higher, and several analysts suggest that it is more than $110 billion.
As China and other emerging markets sell U.S. treasuries to defend their own currencies (the proceeds from the bond sales are used to buy domestic currency and increase its exchange value), it puts pressure on bond yields in the U.S.
When the Treasury bond market’s average price falls, its yield rises, putting upward pressure on borrowing costs for U.S. businesses and consumers.
If the stock markets in Japan and the U.S. have reached short-term bottoms, this selling pressure in the bond market could increase as return chasers move from bonds into stocks again. This means that the market is already undergoing a natural tightening process.
So far, interest rates have remained relatively flat, but economists estimate that each time another $500 billion worth of bonds are sold, rates in the middle of the yield curve will bump up by a percent or more.
As you can see in the next chart, long-maturity bonds have continued to fall following the blowout on Aug. 24. Although this all sounds a little bit scary, would the combination of higher interest rates and falling bond prices be a bad thing for stocks?
Whether rising rates are good or bad for the market is a tougher question to answer than you might think. Rates were increased 17 times between 2004 and 2006, which did nothing to stop the stock and housing markets from massive bullish rallies that actually led to a significant bubble.
However, there are a few differences this time. If the market is already naturally tightening as bond sellers emerge, the Fed will be increasing (or tightening) interest rates into a falling bond market. That could continue to put pressure on emerging markets and their $7 trillion in foreign exchange reserves (comprised largely of U.S. Treasury bonds). This, in turn, could increase longer-term borrowing rates more than expected.
In our view, the Fed is in a lose-lose situation. If it tightens in September (which we believe it will), it could trigger a feedback loop that drives interest rates high enough to constrain growth. However, if the Fed doesn’t raise rates, it would signal a lack of confidence. Traders can be very fickle and, as we have seen over the last three weeks, small events can trigger fast adjustments.
We are cautiously optimistic that stocks have put in a short-term low at this point and are unlikely to go lower before earnings season kicks off next month. However, uncertainty in the bond market and in China is significant enough to keep current levels of volatility very high.
We expect stocks to continue to oscillate back and forth in an unusually wide range as we get closer to the Fed’s announcement on Sept. 17. On the bright side, however, this should present some very exciting opportunities for short-term gains in the option market.
InvestorPlace advisers John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next SlingShot Trader trade and get 1 free month today by clicking here.
You can learn more about identifying price patterns and using them to project how far you think a stock is going to move in their Advanced Technical Analysis Program.
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