It’s normal for the stock market to ignore a rising interest-rate trend for a long time. The reason is that while the interest rate is a major determinant of the value of most corporations, the interest rate that matters for equity valuation isn’t the current one. What matters is the level of interest rates for a great many years to come. Therefore, a rise in interest rates only affects the stock market to the extent that it affects the general perception of where interest rates will be over the next decade or longer.

To further explain, the value of a company is the sum of the present values of all its future cash flows, with the present value of each future cash flow determined via the application of a discount rate (interest rate). Nobody knows what these cash flows will be or what the appropriate discount rate should be, but guesses, also known as forecasts, are made. Clearly, when discounting a set of cash flows spanning, say, the next 30 years, it won’t make sense to simply use the current interest rate. Instead, the analyst doing the calculation will have to make a stab at what will happen to interest rates in the future.

The analyst’s ‘stab’ naturally will be influenced by what is happening in the present, but the future interest rate levels that are plugged into valuation models won’t be adjusted in response to what are considered to be normal fluctuations in the current interest rate. It’s only when the current interest rate breaks out of an established range that it affects expectations in a big way.

That, in a nutshell, is why it isn’t a fluke that the 3rd October downside breakout in the bond market (represented by TLT in the following chart) coincided with the start of a rapid downward re-pricing in the stock market.

In addition to stocks being influenced by big moves (breakouts from ranges) in bonds, bonds are influenced by big moves in stocks. That’s especially so when important stock-market support levels are breached with little warning. For example, within a few days of the 3rd October downside breakout in the bond market setting in motion a sharp decline in the stock market, the stock market’s weakness was helping to prop-up the bond market. Interestingly, though, the quick 10% decline in the S&P500 Index from its peak led to only a minor rebound in the bond market, despite there being a record-high speculative net-short position in bond futures. As illustrated above, TLT didn’t even manage to rebound by enough to test its 3rd October downside breakout and has dropped back to near its early-October low in response to this week’s recovery in the stock market.

The bond market’s lacklustre response to the recent equity weakness suggests that equities will have to weaken further before the interest-rate trend transforms from a stock-market head-wind to a stock-market tail-wind. Also, the fact that the bond market has already dropped back to near its October low suggests that the stock market will be unable to make significant additional gains without pushing interest rates to new multi-year highs. This, in turn, suggests that there is minimal scope for additional short-term strength in the stock market.

There is an age-old relationship between prices and interest rates that Keynesian economists have called a paradox (“Gibson’s Paradox”). The relationship was clearer during the Gold Standard era, but as I explained in a previous post it is still apparent if prices are measured in gold.

To understand “Gibson’s Paradox” and why it actually isn’t a paradox, refer to the earlier post linked above. Suffice to say that when money is sound or at least a lot sounder than it is today, interest rates don’t drive prices and prices don’t drive interest rates; instead, on an economy-wide basis both prices (in general) and risk-free interest rates are driven by changes in societal time preference. Moreover, as mentioned above and explained in my earlier post, even with today’s massive, continuous manipulation of interest rates by central banks the relationship is still evident, but only when interest rates are compared to a wholesale price index denominated in gold.

The commodity/gold ratio is the price of a broad-based basket of commodities in gold terms. In essence, it is a wholesale price index using gold as the monetary measuring stick. Also, the risk-free US interest rate that is least affected by the direct manipulation of the Fed is the yield on the 30-year T-Bond, so if the age-old relationship still works then what we should see is a positive correlation between the commodity/gold ratio and the T-Bond yield. Or, looking at it from a different angle, what we should see is a positive correlation between the gold/commodity ratio and the T-Bond price. That’s exactly what we do see.

Using the Goldman Sachs Spot Commodity Index (GNX) to represent commodities, the following chart shows that the age-old relationship has worked over the past 12 years when gold is the monetary measuring stick.

The next chart zooms in on the most recent 2 years and shows that over the past three weeks there has been a significant divergence, with the gold/commodity ratio turning upward and the T-Bond price staying on a downward path. It’s a good bet that this divergence will be eliminated within the next two months via either a decline in the gold/commodity ratio to a new multi-year low or a rebound in the T-Bond. My money is on the latter.

This post was prompted by a recent article authored by the always thought-provoking Pater Tenebrarum (a pseudonym) at acting-man.com. The article looks at the relationship between credit spreads and the stock market, in particular the historical tendency for credit spreads to begin widening prior to substantial stock market declines and thus to act as timely warning signals of impending stock market trouble. The conclusion is: “…it seems…more likely that a stock market decline will put pressure on junk bonds, instead of weakness in junk bonds providing advance warning of an impending stock market decline. The stock market sell-off in the past week did in fact very slightly lead a surge in high yield spreads.” I don’t know that this conclusion is wrong, but at this time the evidence to support it is not persuasive.

It first should be understood that credit spreads generally begin widening ahead of bear markets, but they generally DON’T lead short-term stock-market corrections. Therefore, the fact that they didn’t warn of the October-2018 sell-off is not meaningful at this time. It will become meaningful only if the October-2018 sell-off proves to be the first decline in a bear market, which is unlikely.

The fact that the most recent stock market sell-off appeared to slightly lead an up-tick (not a surge) in high yield spreads is also not meaningful. The following chart shows that junk bonds often trend with equities (the chart compares the iShares High Yield Corporate Bond ETF with the S&P500 ETF), so actually it is normal for short-term stock market corrections to go hand-in-hand with minor expansions of credit spreads. That’s what happened over the past 2 weeks, what happened in January-February of this year and what happened on numerous other occasions in the past.

The above-linked article makes the interesting point that credit spreads in the euro-zone and the US have diverged over the past year, with the former embarking on a widening trend in late-October of last year while the latter continued to contract. If credit spreads were still useful leading indicators of major stock-market trends then this divergence should have been accompanied by dramatic relative weakness in European equities. Since it was accompanied by dramatic relative weakness in European equities this is hardly evidence that credit spreads have lost their usefulness.

Could the influence of QE prevent credit spreads from signaling a trend reversal ahead of the next equity bear market?

I don’t see how. QE led to yield-chasing behaviour, which, in turn, caused credit spreads to become a lot narrower than they would have been. Having been compressed to artificially small quantities, credit spreads should if anything be more sensitive than usual to changes in the financial and economic backdrops.

Summing up, credit spreads have a strong tendency to widen ahead of equity bear markets. It could be different this time, but right now I can’t think of a good reason why it should be different. In any case, there is no need to rely on just one leading indicator.

I’ve read many comments to the effect that the next financial crisis will be like 2007-2008, only worse. However, the sole reason that many people are talking about a coming 2008-like crisis is because the happenings of 2008 are still fresh in the memory. Market participants often expect the next crisis to look like the last one, but it never does. Consequently, the general prediction about the next financial crisis with the highest probability of success is that it won’t be anything like 2008. It could, for example, revolve around an inflation scare rather than a deflation scare. In fact, the current monetary system’s ultimate financial crisis, meaning the crisis that leads to a new monetary system, will have to be inflationary.

The ultimate financial crisis will have to be inflationary, because deflation scares provide ‘justification’ for central bank money-pumping and thus enable the long-term credit expansion to continue with only minor interruptions. To put it another way, a crisis won’t be system-threatening as long as it can be ameliorated by central banks doing what they do best, which is promote inflation.

A related point is that a crisis won’t be system-threatening as long as it involves an increase in demand for the official money. The 2007-2008 crisis was such an animal. Like every other crisis in the US since 1940 it did not involve genuine deflation, almost regardless of how the word deflation is defined. The money supply continued to grow, the total supply of credit did no worse than flatten out, and, as illustrated by the following long-term chart, there was nothing more than a downward blip in the Consumer Price Index. However, with the stock market losing more than half its value and commodity prices collapsing, for 6-12 months it sure felt like deflation was happening.

Chart source: dshort

What actually happened during 2008 was a deflation scare, as opposed to genuine deflation. I define a deflation scare as a period when the total supply of money and credit continues to grow, but a surge in the demand for money makes it seem as if the economy is experiencing severe deflation.

Since there is no limit to the amount of new money and credit that can be created out of nothing by the central bank, it will always be possible for the central bank to keep the current system going in the face of a crisis that involves a surge in the demand to hold the official money. The problem (for the monetary authorities) will occur when the crisis involves a plunge in the demand for the official money. In such a situation the central bank’s most powerful weapon becomes not just ineffective, but counter-productive*.

The bottom line is that regardless of its other details, if the next crisis involves deflation or a deflation scare then it will be just another bump in the road. It will prompt another bout of aggressive money-pumping that will alleviate the perceived shortage of money and eventually inflate new investment bubbles. Only a crisis that entails a decline in the desire to hold the official money can be an existential threat to the monetary system.

*Creating money out of nothing is always counter-productive if the goal is to hasten long-term economic progress, but it can be productive if the goal is to prolong the existence of a debt-based monetary system.