Friday, 23rd April 2021
ASX 200 Index (XJO)
During the week, the XJO fell over 100 points intra-day. However, the market turned near the 6900 point level and closed down only 20 points on the day. We can see the rejection of lower prices on the chart below. We also point out the weakening MACD and Stochastics indicators. It would appear that the market wants to move higher but the low volume we have mentioned repeatedly in the morning report is not a good sign for the bullish case.
The all time high for the XJO is 7197 points, set on 19th of February 2020. Just over a month later, the XJO was trading at 4402.
We have all heard about Central Banks, but did you know that their role is to maintain inflation at a pre-determined target somewhere around 2% per annum? This means that they concentrate on interest rates and the long held belief is that Central Banks can set rates that the market will follow. There is no truth in this statement. Central Banks follow the market.
The only rate a Central Bank, such as the RBA, sets is the ‘cash rate’. This is the rate on unsecured overnight loans between banks. In Australia, the rate has been set at 0.10% since November 2020. In 2008 this rate was 7.25% and in 1990 it hit a high of 17.5%.
Interest rates reflect demand for credit and the higher the demand, the higher the interest rate. This edict doesn’t work when there is a collapse in credit markets, as higher rates are a result of lenders wanting higher returns in uncertain times.
The purpose of the above discourse is to show that interest rates have been declining for over 30 years. In that same time, debt has exploded as people and all levels of government take advantage of lower rates to pump funds into the system. Economists believe that this action by governments and Central banks will stimulate the economy. Nothing could be further from the truth as global growth rates have been declining in the past 30 years as well.
What can we learn from a 30 year decline in interest rates?
Since September last year, US 2 year Treasury notes have more than tripled in yield. Other yields have risen as well and recently the market is concerned that inflation is just around the corner. Inflationary pressures would not be a good thing for the economy as this would fuel further rises in rates to attempt to quell the rising prices.
The last time that inflation was low and unemployment below 5% (as it is now), was in the late 1960’s. In America, the government policy was to continue spending on policy known as the Guns & Butter time. This was during the Vietnam war where increased defence spending and welfare payments (the butter component) saw inflation hit 6% in the following 2 years.
The subsequent decade saw the inflation genie escape the bottle and by that time the global economy had settled down. Wall Street had lost 60% in value and interest rates were in double figures. The only places that investors ‘made’ money was in property and commodities.
Fast forward to now and we are starting to see the same cycle start again. Central Banks have issued debt at eye-watering levels, unemployment in America is close to 5% and retail spending surged last month. The budget deficit for the US will be 15% of GDP this year and the prudent approach would be to increase taxes and rein in government spending.
The current US administration is locked into a trillion dollar infrastructure program and the current growth of money supply is 4 times higher than in the 1960’s. The Fed is determined to continue its QE program at US$120bn a month and with estimates of a US$2 trillion savings hoard from US households since the pandemic started, increased spending appears inevitable.
At the moment, the official view of the Fed is that inflation will spike to 2.4% this year and then quickly subside.
There are few moments that the Fed (or any Central Bank for that matter) have successfully negotiated policy when faced with the current conditions. In bull markets, when optimism is rising, leaders of Central Banks are lauded as economic magicians. However, when faced with a scenario of extreme debt, locked-in government spending and runaway retail spending, the response from these bankers is to hold rates too low for too long and then play catch up and overreact.
It would appear that the current economic scenario has given us the following economic scenarios;
1. Inflation explodes higher and interest rates are increased in an attempt to curb rising prices.
2. There is a credit crunch as the sheer size of the debt leads to a loss in confidence that credit will be repaid, resulting in higher interest rates.
3. Economic conditions improve as a result of a successful reopening of global economies after the pandemic and interest rates rise in response.
Whichever way, it would appear that we are at the start of a rise in interest rates. This normally has detrimental effects on share prices as the equity risk becomes too large. Bond markets are savaged as rising rates leads to capital losses for existing bond holders. Households with too much debt, especially mortgage debt, are put in a perilous position of negative equity in their households.