The stock market has improved a bit over the past couple of weeks, but this is not the time to get complacent and think this tough market is over and good times are back.  The US government must break a vicious circle of inflating interest rates before we can start breathing easier.  Let me explain as simply as I can. 

The US is facing two deficits, a budget deficit and a trade deficit, which together total $3.6 trillion.  (Source: CNBC and US News).  Deficits must be financed with the sale of additional Treasury bonds or government checks may start to bounce.  In theory this could impact things like your social security check. 

This flood of new Treasury bond sales means the supply of bonds is increasing, just as interest rates are pushing up the price the government must pay (the interest) to sell the bonds. 

Foreign countries have historically liked buying our bonds because the US was perceived as more stable than many parts of the world, making the US a “safe” place for another country’s “savings.”  However, foreign demand for US bonds is dropping.  Of our two largest bond holders, Japan is no longer adding to their bond holdings and China has actually sold some, reducing the size of their US bond portfolio.  (Source: Investopedia). Foreign governments, like all bond holders, are seeing inflation whittle away the real value of their bonds, so it may just be a shrewd investment move by them to buy fewer bonds.  It is hard to tell what they are really thinking. 

So, the need to sell more bonds just as demand is falling off summarizes the predicament our government is in. 

You may have noticed that interest rates have risen sharply this year.  What everyone wants to know is: how high will rates go? 

Interest paid on 10-Year Treasury Notes has been hovering around 3% the last month or two, after doubling since December.  The long-term average rate on 10-Year Treasuries is just under 6%, meaning that interest rates would have to double again just to get back to average.  

We had zero interest rates two years ago, and markets don’t go from an extreme like that to quietly back to average.  They snap wildly in the opposite direction, creating the average somewhere in the middle.  This suggests that we may see generally rising 10-Year interest rates until we are well above 6%.   

The conundrum the Feds face is that higher rates will increase the amount of interest the Federal government must pay.  Since interest expense is part of the budget deficit, that will require even more bond sales to balance the budget deficit, making the supply/demand imbalance even worse.    

In my view, the government has a couple of choices: 

One, it must slow the economy to bring prices under control.  But the most common way governments do that is by raising interest rates, which will compound their budget deficit problem.  And often, efforts to slow the economy create a sharp economic recession.  In recessions, governments normally sell bonds to get money to stimulate the economy. In doing so, they would be increasing the supply of bonds even more, forcing rates even higher.  Sort of a Catch-22. 

The other option is for the government to allow the economy to run hot and interest rates to rise as demand for bonds falls off under the threat of even more inflation.   

In defense of the government, they have been pretty creative during past financial crises, coming up with solutions that I could not imagine.  But, no one and no thing, even the government, is more powerful than free markets.  The US Government may be in the process of learning that lesson as interest rates spiral out of control. 

Neither of these scenarios has a happy ending, so as investors, we must remain prepared for the bear market decline to resume until a resolution to the pickle the government finds itself in becomes evident.  There are always tradeable rallies in bear markets.  I think we are in one now as the major stock indices have risen gently over the past five weeks.  (This writing is on July 25th.) 

But I don’t hear the proverbial fat lady singing, so I don’t think this bear market is over.  

What is one to do?  Retreating to CDs will just let inflation eat up the purchasing power of your dollars.  If you put $100,000 in a CD a year ago, you could get your $100,000 back this year plus a little interest.  But you could only buy around $90,000 worth of goods and services.  That is the result of the reported 9.1% inflation over the past year.  

Long-term holdings of bonds or bond funds involve more risk than investors have seen for several decades, so that is not something I can recommend. 

Even gold is down over the past year, so that has not been a good refuge for investors, either. 

In my opinion, proactive management of one’s assets, which allows for investing in tradeable rallies and a retreat to cash when the market trends down again, is the only thing that has been helping investors avoid index-like losses in this environment.   

At Shadowridge, we reduce market risk by moving out of the market and into cash during declines.  This allows us to stay involved enough to be ready for the buying opportunity of a lifetime that inevitably follows a big bear market.  So, if you are already a client, you are in good shape.  If you are not yet a client, contact us to see how our proactive management could benefit you when the bear begins showing its teeth again.