Over my 40+ years of trading I have learned that the one thing that can kill a bull market is the Fed’s raising interest rates.
When interest rates rise the price of bonds decreases. This is because the dividend paid by bonds is usually fixed. This is why the media often say that a bond moves inversely to interest rates. Most people find this difficult to understand. So here is how I teach my students. Say a bond is issued a $100 and it pays the holder $3 per year. That $3 is fixed for the life of the bond that might extend for many years. If the $100 bond pays $3, its yield= 3% each year (3/100). Now say that interest rates rise over a few years to 6%. Then new $100 bonds issued will pay $6 per year (=6%). Someone holding the older bonds (that pay $3 per year) if he wanted to sell his bond early and get his money back would likely be offered only about $50 for his bond which he had bought for $100. Remember the annual payment was fixed at $3 per year. Thus $3/X (price of bond)=6%. By solving this equation with rudimentary high school algebra, one realizes that x=50. Thus a person selling his original bond in the environment where new bonds now pay 6% would be offered only about $50 in the resale market. The new buyer will only be willing to pay half of what the bond was originally issued at in order to get the prevailing 6% return. Thus when interest rates double, a person’s bond loses one half of its value, if it is being sold long before maturity. None of this applies if one holds the bond until maturity because the person will get his $3 each year and then the full $100 back when the bond matures and the person is repaid his principal.
All of the above is to explain why the trend in bonds may be worth watching. If bonds start to decline, it means that investors see rising interest rates ahead. It is for this reason that I am a little concerned by this chart of TLT, the 20 year treasury bond ETF. It looks to me like we may have put in a double top, indicating that interest rates may have bottomed out. Note the big decline on Tuesday. (Click on chart to enlarge.)
If the economy is heating up, the Fed better raise rates so that it has ammunition to fight the next economic downturn. Here we go again…….
Meanwhile, Happy Holidays to all!