Watching Bonds Is the Easiest Way to Predict the Next U.S. Stock Market Crash

Consider bonds. They’re worth keeping under scrutiny now because they are signaling some inherent market weaknesses. Bonds are telling the big story when it comes to the next—make that the imminent—stock market crash.

The jolt that the stock exchanges have experienced between the end of last January and the start of February may turn out to be a mere appetizer. Stocks on Wall Street could reserve some major, heavy, greasy courses for investors to confront. This is no celebrity chef event. There are some key indicators that point toward a deeper correction or, worse, a major stock market crash. (Source: “U.S. Stocks Fall With Treasuries, Dollar Climbs: Markets Wrap,” CNBC, February 20, 2018.)

The key to the market downfall is that bond yields are going up and bond prices are going down. That tells the relevant economic authorities—like the Federal Reserve—to prepare for higher inflation. Now, it seems investors better prepare because the much-talked-about higher interest rates are coming; as many as three in 2018 alone. But in 2019, the pace of rate hikes could increase.

Treasury yields are moving higher. They do so when those in charge of such things notice that consumer prices are increasing. Inflation is now approaching three percent. Normally, inflation going up pushes gold prices higher and stock prices lower. For the time being, stocks are stable or slightly higher. But it won’t be long before the higher rates will become official. The next Federal Reserve decision is scheduled for March 21. It’s going to be Jerome Powell’s first. Trump chose him because he had a reputation for not favoring stability.

The Fed Has Few Tools Against Inflation

But, as everything suggests that inflation is going higher, there’s little Powell can do. The 0.25% hike is a sure thing. A 0.50% hike cannot be excluded because the U.S. dollar, despite the confused miscommunication between Treasury secretary Steven Mnuchin and President Trump—who can’t seem to agree whether they want a strong or a weak greenback—is slipping against all major currencies. For example, the European Central Bank continues to practice quantitative easing (QE). Therefore, the EURUSD exchange rate is still artificial.

Should the Fed adopt a 0.50% rate hike, it could cause a stock market crash and even a snap recession. Many investors will find it too difficult to sustain any loans (or margins) they have taken to remain in stocks. They will start to pull out; especially as the Fed could raise rates three times in 2018. Meanwhile, inflation will continue to rise, formally ending the magic era of borrowing at no cost. Prepare for a major market correction. Indeed, the economy is staring at the face of another recession by the end of the year.

If you’re thinking that the three interest rate hikes since December 2015 have not caused stocks to fall, you might be observant. But you would not be astute. Yes, the higher interest rates so far have failed to inflict serious damage to the stock market. But what will happen in the near future? The late January adjustments at the end of January served as proof that the stock exchanges have gone too high. The next rate hike could prove it.

The Stock Market Is Like the Titanic

Wall Street is like the “Titanic” now. It’s sailing along, remaining comfortably near its record highs. But, there are some sharp obstacles—icebergs (forgive the cliché)—below the surface. The bond yields are one of these. But one of the three hikes that many expect in 2018 could be the fatal one that causes everything to collapse.

But, these “icebergs” have a common origin: the Trump tax cuts. These have distorted the economy, doing nothing about income distribution while encouraging much short-term speculation. The tax cuts can also serve as a microscope for looking into the logic of then-big corporate magnates. They have repatriated billions of dollars. Apple Inc. (Nasdaq:AAPL), Amazon.com, Inc. (Nasdaq:AMZN), and Facebook Inc (Nasdaq:FB) have announced bringing monumentally large sums of money held abroad back to the U.S.

These moves are all signs that the big shots expect rate hikes and higher interest rates. They have repatriated their foreign earnings, sitting pretty but earning little interest abroad, to the U.S. Back home, the huge sums of capital will not only benefit from lower tax burdens but will also earn steadily increasing interest rates. But will they produce higher earnings after investors take note of the initial repatriations?

There’s a risk that stocks will move up again, riding on the inevitable wave of stock buybacks that companies will be busy making. Such buybacks artificially inflate the market until someone—those in the know—pulls the plug, takes their profits, and sparks the next stock market crash.

The first weeks of 2018 have proven that there are few guarantees in life and in markets. Everything seemed to indicate a continued bull run as the Dow rose above 26,000 points with ease. The problem, however, when things seem too easy, is that nobody makes any room for disruption. And, rather than boom, 2018 could turn out to be a year of a bust if not downright misery.

There are good odds that one or more disruptive events—or “black swans”—could occur to spoil the party and lower the value of our portfolios. These situations catch my attention as potential brewing grounds for black swans. Unfortunately, given the nature of such events, they can only be identified in hindsight. Still, it’s good to be aware that not everything that glitters is gold.

Deutsche Bank AG (NYSE:DB) expects the real estate bubbles that have fueled a false sense of prosperity and market optimism in Canada or China could spread to the equity markets, triggering a correction. (Source: “A bitcoin crash, a burst housing bubble — giant bank sees 30 risks to markets for 2018,” MarketWatch, January 2, 2018.)

Then, there’s the Bitcoin bubble. Even after the “correction,” the Bitcoin market cap is still worth more than some of the largest businesses on Wall Street. Should the correction turn into a crash, pushing Bitcoin values toward zero, as Nouriel Roubini expects, it would hurt investor confidence throughout and trigger a crash.

Then there are the more American problems. These are the ones everyone should beware because their effect on Wall Street could be more intense. Yes, the U.S. boasts a low unemployment rate. But apart from the fact that many of the jobs pay less than $25,000/year (Walmart Inc (NYSE:WMT) anyone?), everyone will be affected if inflation moves higher than the Fed expects. The valuation of U.S. equities in price to earnings (P/E) ratios could become untenable and burst, resulting in massive profit taking and a shift in equity investments to Europe and emerging markets.

As for the political risk, it is likely that there will be a reversal of the Republican majority in the mid-term elections in November. If this happens, political instability would pull Wall Street down.

And then there’s the good ole’ American politics. Even if the Mueller investigation of alleged Russian meddling in the 2016 presidential election fails to indict any big names around President Trump, it could cost the Republicans the House and Senate majorities.

And of course, the PyeongChang Olympics have not changed the People’s Republic of Korea, even if it has participated in the great peace-themed fanfare. Kim Jong-un remains in charge. And he seems determined to launch long-range ballistic missiles tests. These could push tensions in an ever more unpopular White House; the tension will become untenable.

Finally, there are no guarantees that China can avoid a downturn in the Chinese economy, which could also change the Asian economic landscape. Oh, and inflation could affect Germany as well.