by Alasdair Macleod, GoldMoney:

There is a growing recognition in financial circles that price inflation will increase significantly in the near future, and official estimates that it will be a temporary phenomenon limited to an average of 2% are overly optimistic. There is, therefore, increasing speculation about the need for interest rates to rise.

The bond yield on 10-year US Treasuries has already more than doubled over the last year. It is in the nature of market cycles for equity and other financial assets to continue to rise in value during an initial increase in bond yields. It is the second increase that can be expected to turn bullish optimism about the economic outlook into the beginning of a bear market. Financial markets, already dislocated from fundamental realities, appear to be acutely vulnerable to such a change in sentiment.

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This article points out that equity markets are driven more by money flows rather than perceived economic prospects. Bank credit for industry is contracting, commodity prices are soaring, and supply chains remain disrupted. Fuelled by earlier expansions of money supply and further expansions to come, the world faces a far larger increase in price inflation than currently contemplated, and therefore far higher interest rates, threatening to destabilise both financial markets and fiat currencies.

Introduction

There is a rustling in the undergrowth, disturbing the sylvan setting where we complacently enjoy the dappled sunlight, innocently unaware of the prowling bear. The bear heralds another rise in bond yields as we grapple with the inflationary consequences of recent and current events.

Public participation in equity markets is at an all-time high, not just through direct holdings — amateurish speculation is rife — but through passive index tracking funds and the like. With respect to these, the underlying assumption financial advisors make and tell their innocent clients is that trackers are risk free, because exposure to individual corporate failures is so diluted as to be immaterial. And over time, markets always rise, captured by investing in these funds. But this is deception, ignoring market cycles and systemic risks. Ignorance of the inevitable cyclical switch from greed for profits to fear of loss that defines the divide between bull and bear markets invalidates the permabulls’ advice.

Without doubt, the prowling bear in our so far untroubled scene is bond yields. Unnoticed, they have begun to rise as shown in the chart heading this article. With increasing urgency, it is time to consider the effect on market relationships. Over many investing cycles it has been observed that bond prices conventionally top out before equities. It is one of the most reliable warning signs, which, despite its track record is routinely dismissed by wishful thinkers until it is too late.

Instead, it is a commonplace to argue that prospects for corporate profits have improved at this stage of the economic cycle because of the growing certainty of a better economic outlook. And now that this time the civilised world is emerging from lockdowns, every analyst in the mainstream media delivers this message. For them, the rise in bond yields confirms that improving business conditions are in place to justify yet higher equity prices. But it is all a cycle, having little to do with economic prospects.

Today, we see that the relationship between declining bond prices and rising equities, and all the sentiment and commentary around them, are as we should expect.. But beware the bear lurking in the woods. It’s the second rise in bond yields that often slays the equity bull. I vividly recall meeting an industrialist the autumn of 1972, who told me that his business was the best it ever had been. He then paraded his ignorance of financial matters by telling me that it was wholly irresponsible for the London Stock Exchange to permit the FT 30 share index to have halved in the previous fifteen months. Following that conversation, the FT 30 halved again after interest rates were jacked up in October 1973, creating the infamous secondary banking crisis and losing 70% from its peak in May 1972 by January 1975. And the last I heard of the unfortunate industrialist his business had gone bust and he had committed suicide.

It is a mistake to take opinions or evidence of economic conditions as the principal reason to invest in equities. It is more important to follow the money, specifically the cycle of bank credit. While amateur investors are buying into equity market tops, bankers begin to see that the early signs of rising interest rates are disrupting business plans and will lead inevitably to corporate failures. This comes at a time when their own balance sheets are most highly leveraged. With this credit cycle, there are some additional features specific to it. Even though the ending of pandemic restrictions is expected to lead to a substantial recovery in economic activity, these extra features are extreme, and the bear case is therefore strong.

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