Last week was a week of records. The Dow and S&P closed at new highs. The NASDAQ closed at its highest level in six years. Oil closed at $74 a barrel, an 11 month high. The Euro hit an all-time high against the dollar. It now takes over $1.38 to buy one Euro. (My sympathy to all of you vacationing in Europe this summer.) 

 

Twice last week I read/heard commentators saying that rising oil prices are good – they’re a sign of a strong economy. The talking heads glass is half full (and I think it’s filled with something stronger than water). Rising energy prices worry me. They take money out of the consumers pocket, add to inflation and increase our balance of payments deficit, leading to higher interest rates. Sorry, my glass is half empty on this one, but maybe I’m just old school.

 

Something else happened last week, which received almost no press. Credit spreads widened. This means the yield on junk bonds rose, even though the Treasury market was flat. Why did junk bond yields (and the cost of financing with junk bonds) go up? It could be due to ongoing problems in the subprime market and/or the amount of private equity transactions which need financing. Or it could be something more ominous.

 

The bond market has been better at calling turns in the economy than the stock market. The players in the junk bond market are really smart guys (and women). If their glass has gone from half full to half empty we better beware.

 

Here’s how events could play out. Rising interest rates in the junk bond market ripple through all classes of debt. The continuing record trade deficit and the declining value of the dollar cause foreigners to demand higher returns to hold US Treasuries. The result is both rising interest rates and rising credit spreads (making junk debt financing more expensive/driving the price of existing bonds lower).   The tipping point from rising interest rates to a full blown credit crisis is a debacle in the subprime market or the inability for a private equity firm to finance a big transaction (think Chrysler, Hilton, Sallie Mae). 

 

Interest rates will rise and, at some point, the stock market will switch from viewing the glass as half full to half empty. Soon, I think.