Research & Commentary

What to Expect for Interest Rates During Deflation

The best time to prepare for a major financial change is before it happens. With that in mind, Elliott Wave International has been preparing subscribers for what we see around the corner by reviewing what has happened in the past regarding interest rates.

 

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[Editor’s note: The text version of this video is below.]

There have been two official deflationary depressions in United States history: 1835-1842 and 1929-1932. Of course, there was also the 2007-2009 financial crisis with its severe liquidity crunch.

Published in 2002, Prechter’s Conquer the Crash foretold of “bank failures, pension-fund stresses, the implosion of collateralized securities, the formation of government bailout schemes, the failure of the big bond-rating services to issue warnings … and [a] simultaneous fall in real estate, stocks and commodities, all of which happened” during the 2007-2009 financial crisis.

Right now, U.S. stock prices remain elevated, and the nation’s latest annual inflation rate is 2.7%, according to the Bureau of Labor Statistics. So, it might strike you as odd to even broach the subject of a deflationary depression.

But, it’s well to remember that both of those deflationary periods, as well as the 2007-2009 financial crisis, were preceded by good financial times. So, it’s good to educate ourselves in case another deflationary depression happens.

With that said, let’s consider your portfolio and these words from the third edition of Conquer the Crash:

If there is one bit of conventional wisdom that we hear repeatedly with respect to investing for a deflationary depression, it is that long-term bonds are the best possible investment. This assertion is wrong. Any bond issued by a borrower who cannot pay goes to zero in a depression. In the Great Depression, bonds of many companies, municipalities and foreign governments were crushed.

This leads us to a related discussion in the just-published April Elliott Wave Financial Forecast:

Bond bulls contend that rates will fall if the economy contracts and deflation regains the upper hand. Here are some historic charts that support our case for a rise in interest rates despite deflation and depression.

The chart above shows that high-grade bonds went from 5.57% yield at the beginning of the bear market and deflationary depression in 1835 to 10.35% at its end in 1842. There were no Treasury bonds in that era, but New York State bonds are a good proxy. They rose too as rates on these bonds went from 4% in 1835 to 6.6% in 1842.

This next chart shows the performance of Baa bond yields during the bear market that kicked off the Great Depression. Rates started to rise from a level of 5.32% in March 1928, 18 months ahead of the September 1929 peak in stocks, and continued up to 11% in July 1932, the last month of the Supercycle-degree bear market in the DJIA.

With all of the above in mind, consider this April 5 CNBC headline:

Why mortgages, other interest rates could go up faster than you think

Indeed, the yield on 10-year U.S. Treasury notes hit an all-time low of 1.36% on July 8, 2016 – and jumped to a 2.63% high on March 13.

Even though yields have since pulled back a bit, EWI’s analysis reveals a bigger trend that should concern every bond investor.

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