When money is available at inexpensive cost levels, investors are willing to take on greater risk because they are able to leverage the lower cost structure for potentially higher returns. This has been clearly demonstrated over the past 12 months with the government's lower interest rate initiatives causing liquidity to flow into securities markets.
This flood of liquidity has helped stabilize an economy that was sinking in quicksand as early as last March 2009. Equity and energy markets have been a major benefactor of this tidal wave of cash allowing the S&P 500 to rise an astonishing 400 points and crude oil $50 in only one year.
When will the party end?
The bond market has always been the adult at the party keeping equity and energy from getting too wild. High liquidity eventually brings the fear of inflation. Bond buyers on the long end of the curve are beginning to demand higher interest rates to compensate an increased risk of inflation. The 10 year and 30 year bond yields are pushing upper range resistance levels, which if broken eventually raises borrowing cost for investors.
The ultimate result of higher interest rates are a slow down in economic development. This eventually leads to the equity and energy markets finding more sellers than buyers as investor's costs rise with the higher interest rates.
Energy traders will be monitoring closely the 10 year treasury yield which closed Friday at 3.86. This is just slightly below its one year resistance level of 4.01. Should resistance be broken on a weekly close, energy and equity traders will begin being hit with higher costs, resulting in less liquidity flowing to the markets. And once again the bond market is likely to efficiently tame the crude and equity party animals.
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