Yield Curve Continues to Flatten
(December 15, 2005)
Dear Subscribers and Readers,
We switched from a 25% short position in our DJIA Timing System on the morning of October 21st at DJIA 10,265 - giving us a gain of 351 points from our DJIA short on July 14th. On a 25% basis, this equates to a gain of 87.75 points. For now, we are still completely neutral and in cash. The market is still very overbought and retail investors' sentiment is still too bullish. However, it has always been dangerous to short stocks in December - as this period of relatively quiet time has historically encouraged hedge funds and mutual funds to squeeze short sellers in stocks that have high short interest. For now, there are no current plans to do anything in the stock market on a macro basis - any new short or long positions will most likely be initiated after the New Year's.
Readers who have been keeping track of our discussions regarding currencies and all my postings in our discussion forum should realize that over the last couple of weeks, this author has developed a fondness for the Yen - with an additional emphasis of the cross rate between the Euro and the Yen. In those commentaries, I had discussed that the cross rate between the Euro and the Yen (Yen per Euro) was hitting a huge resistance line - a resistance line that dates back 20 years - and given the fundamentals of the two currencies, I had enunciated that the time to buy Yen and sell Euro was close at hand (okay, the cross rate did poke above the resistance line a little bit but trading isn't supposed to be easy!). The action in the currency markets yesterday fully confirmed my views, as the Yen made a huge up-move - appreciating more than 2% against both the U.S. Dollar and the Euro by Wednesday afternoon. The secular bull market of the Yen against the Euro has resumed!
The big news over the last couple of days was the change in the accompanying statement of the Federal Reserve meeting, since the hiking of the Federal Funds rate from 4.00% to 4.25% was already a given. In the accompanying statement, the Fed removed the sentence outlining that Fed policy was still accommodating, while keeping a pledge to keep hiking rates at a "measured pace." As I am typing this, the Fed Funds futures is indicating a virtually certain rate hike at the next meeting on January 31st, while there is a 60% chance of one final rate hike on March 28th.
Given this piece of news, it is no wonder that a significant number of equity bulls and dollar bears out there are now "foaming at their mouths." Even assuming that the Fed doesn't stop until 4.75%, a Fed Funds rate below 5% is still historically accommodative. Logically, this will mean a rising stock market, a rising commodity market, and a declining U.S. dollar. However, the stock market always looks ahead - even as the Fed Funds rates was hiked from a historically low 1.00% to 4.25% from June 2004 to today, most of the major market indices (not to mention precious and base metals such as copper, zinc, aluminum, and lead) have managed to show a significant gain. This has historically been true in most rate hike scenarios as well. That is, instead of looking at monetary policy, the market has historically chosen to focus on earnings growth and final demand of commodities instead. The equity/commodity bulls and the U.S. dollar bears cannot have it both ways. This was very much evident in the precious metals market in the last few days - as the price of both gold and silver continued to decline after the Fed has removed the "accommodation language" in their accompanying statement. No doubt, confusion still reigns - but should the market choose to interpret the Fed stopping its rate hikes as a sign of a slowing economy or slowing earnings growth ahead, then the stock and commodity markets are very vulnerable to a significant correction in early 2006.
As for the U.S. dollar bears - even though this author is bullish on the Yen at the moment - it is important to keep in mind that the Yen only makes up 13.6% of the Dollar Index. That is, even if the Yen goes up 10% tomorrow, the Dollar Index will only go down 1.36% - assuming that other currencies remain stable. By far the most important component of the Dollar Index is the Euro - making up 57.6% of the U.S. Dollar Index. At this point, the Fed Funds rate has a 2.00% "advantage" over the Euro Zone's overnight rates, with a 2.25% spread a sure thing by January 31st. At the same time, there has been no further plans to further hike the overnight rates in the Euro Zone. We also know that the Euro isn't as oversold as the Yen, and that monetary growth in the Euro Zone has been much stronger than monetary growth here in the U.S. and Japan. Also, economic growth in the Euro Zone has historically disappointed, and compared to Japan and other Asian countries, the region really have no current account surplus to speak of. That is, should global speculators focus on trade flows again as opposed to interest-rate differentials, then the rally should continue in the Yen, and not in Euro. At the end of the day, this does not affect the U.S. Dollar Index too significantly, as the Yen only makes up 13.6% of the U.S. Dollar Index.
Some of our readers should also know that the Euro currency is "fundamentally bothersome" to this author. What I mean is this: Similar to the views of Jim Rogers, I believe the Euro is a fundamentally flawed currency. It is next to impossible to conduct an effective single monetary policy for all the countries in the Euro Zone - given demographic, cultural and income differences. True, we have many of these same differences across the United States as well, but the differences are not as profound. Moreover, since the United States is historically a nation of immigrants, we are also very much a jet-setting culture - and therefore, it is usually not too difficult when it comes to adjusting such "imbalances" - whether these balances are in the form of human or monetary capital. Adjusting for these imbalances is much more difficult between France and Italy, for example, not to mention Germany and Turkey. Jim Rogers has previously mentioned that he envisions the Euro to disappear as a currency at some point in the future - we will just have to see.
Okay, enough about currencies - let's get to the heart of this commentary: Is the flattening yield curve a sign of upcoming danger?
In July of this year, the Conference Board officially dropped the yield curve as one of the components of its leading indicator of the economy. There were many explanations, such as:
- Historically, commercial banks have played a huge financing role in the post World War II economy. The traditional role of a commercial bank is to borrow at the short-end of the yield curve and lend at the long-end. Whenever the yield curve flattens or inverts, it does not make sense to do any more new lending. Today, with the maturity of the bond and stock markets (as well as securitization), there is not as much need anymore for businesses to depend on commercial banks for financing - and hence many businesses can still grow at a respectable pace while the yield curve has flatten or invert.
- Expanding on point number one above - since the role of the commercial bank has diminished significantly in the last ten years, this has removed a significant amount of "cyclicality" in the economy as lending risks are now being shared by many more participants in the economy, not just among commercial banks (which, like retail investors, tend to get very aggressive at the top of the market and very cautious at the bottom of the market).
- Many of the new corporations in the post-internet era are no longer capital intensive. The most successful businesses in recent years (Microsoft, Google, Yahoo, eBay, Amazon, Apple, etc.) have adopted a very "capital-light" model. The only tangible assets they have to speak of are their computer equipment. More importantly, they have also continued to cut costs by outsourcing many of their programming and manufacturing functions to overseas economies, such as China and India. Of course, there are always exceptions, such as Wal-Mart, Starbucks, and Intel - but even these companies are relatively "capital-light" compared to "traditional" companies such as GM, Ford, and the railroads.
As a result of this "capital-light" model, the diminishing role of the commercial banks, as well as continued outsourcing - the argument goes - GDP and therefore profit growth are no longer tied to the yield of the long-bond and the short-term borrowing costs (i.e. the Fed Funds rate) of the economy. While these common explanations for the removal of the yield curve as a leading indicator do make logical sense, this author isn't ready to give up yet. After all, doesn't the flattening or inverting of the yield still offer some prediction value - even though that prediction value has been somewhat diminished over the last ten years? It is important to keep in mind that the yield curve still consists of two very important indicators of the economy - that of the rate of borrowing costs on the short-end (i.e. the Fed Funds rate) as well as the yield of the long bond. Today, many investors still buy the long bond if they envision a slowing economy - so the drop of the yield of the long bond over the last couple of days may not only be signaling lower inflation, but most probably also a slowing economy and subsequently slower earnings growth.
One way to look at the historical "shape" of the yield curve is by charting the difference between the yield of the long bond and the Fed Funds rate. Following is a weekly chart showing the differential between the yield of the long bond and the Fed Funds rate vs. the Dow Industrials from January 1997 to the present. Please note that whenever the red line is in negative territory, that means the yield curve has effectively inverted:
Two important things come to mind when we look at the above chart. First of all, readers should notice the flattening yield curve during the time period from January 1997 to October 1998 - which marked the precursor of the 1997 Asian Crisis, as well as the 1998 Russian Crisis and the subsequent blowup of the hedge fund, Long-Term Capital Management. Even though we did not have an official recession subsequent to these crises, we did come relatively close - and the "mini crash" of the stock market in late 1998 wasn't too fun to navigate around either.
Second of all, the flattening of the yield curve and the inversion after April 2000 marked a precursor for the 2001 U.S. recession, as well as the dismal performance of the stock market from March 2000 to October 2002. Please note that this inversion of the yield curve occurred as recently as five years ago. It may be too much of a stretch to believe that the U.S. economy and financial structure has changed so much in the last five years that we should totally ignore the flattening and inversion of the yield curve as both a leading indicator of the stock market and the U.S. economy. As the above chart mentioned, the current spread of the yield of the long bond and the Fed Funds rate of 0.41% is the lowest since April 2001.
Conclusion: This is a relatively short commentary today - this author promises to write more both in our discussion forum in the days ahead as well as in this weekend's commentary. For now, it is important to keep in mind that the removal of the accommodative stance of the Fed Reserve does not change a thing. If anything, it may be a bearish omen - given how the stock market has historically reacted to a change in the rate hike cycle. Moreover, even though this author has turned bullish on the Yen, I am still currently very bearish on the Euro - although I would not be surprised if the Euro continued its rally in the short-run, given the huge speculative short position in the Euro on the Chicago Mercantile Exchange. Finally, the flattening of the yield curve continues to be a bearish omen - even accounting for the significant diminishment of the yield curve as a good leading indicator of both the stock market and the economy over the last ten years.
Henry K. To, CFA