Flattening Yield Curve: Does the Stock Market Care?
(December 22, 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. Since trading volume in the stock market (and in the financial markets in general) will be very subdued over the next ten days, I would recommend our subscribers that any action in the financial markets over this time period should be taken with a grain of salt. Should the market continue to get weaker in the next week or so, one strategy to potentially implement may be to scoop up stocks that have been the subject of tax-loss selling over the last few weeks. Of course, this is only a short-term strategy - probably only good for January unless you have a huge conviction on your individual stock picks. If general liquidity conditions were not so bad and worsening, this author may even have recommended GM for a short-term trade!
Subscribers who have been patient with my short Euro/long Yen cross rate trade were immensely rewarded last week, when the Yen finally mounted a huge advance against both the U.S. Dollar and the Euro. As this author has mentioned before, I believe that the long-term bull market (beginning the time when currencies basically started floating) of the Japanese Yen against the Euro has resumed and is now back in play. Following is a monthly chart of the Euro/Yen cross rate (Yens per Euro) from 1985 to the present - can this short Euro/long Yen trade be any more obvious?
While this author has done relatively well on this trade over the last two weeks (and has not been shy about it), one of the things that have kept me from taking a more risky position in shorting the Euro (against the U.S. Dollar) has been the relatively large short position built up by small and large speculators in the Euro during the two weeks prior to last Tuesday. That being said, however, the latest Commitment of Traders report shows a significant reduction in these short positions, as evident from the following weekly chart, courtesy of Software North LLC:
Like I mentioned in last weekend's commentary, the proliferation of hedge funds over the last five years have now rendered most positions held by large speculators as contrarian indicators as well. Please note the huge net long position built up by speculators in September earlier this year - note that the Euro actually peaked (at US$1.26) at the same time as the peak in speculative long positions in the Euro futures contract! While the amount of speculative positions is still net short at this point, this is definitely not as much of a worry as the huge short position built up by speculators in the two weeks prior to last Tuesday have now significantly been reduced (by approximately 22,000 contracts). Currency investors who are short the Euro here should continue to hold on to their positions.
Let's now get on with the heart of our commentary. In our commentary last Thursday, we discussed the significance (or lack thereof) of the flattening yield curve, as well as the potential implications should the yield curve choose to invert in the coming weeks. We concluded that even though the yield curve may have somewhat outlived its usefulness, it was still nonetheless an indicator to take heed, given its role as an excellent leading indicator of the stock market since the Russian, Brazilian, and LTCM crises during late 1998.
At the same time, last Thursday's commentary actually generated some requests for an extension of our yield curve analysis - i.e. a longer-term chart showing the difference between the 30-year U.S. Treasury rate and the Fed Funds rate. As a result, we have taken our weekly chart all the way back to January 1975 - but since the time period was so long, we have divided this time period into two separate charts - with the first one showing the Fed Funds rate and long bond rate differential (vs. the Dow Industrials) from January 1975 to December 1990 and the latter from January 1991 to the present. Without further ado, let's first take a look at the chart showing our yield curve analysis during the January 1975 to December 1990 time period:
From the above chart, the obvious conclusion for the stock market investors is this: A flattening or inverted yield curve (as signaled when the differential between the yield of the long bond and the Fed Funds rate turns negative) does not necessarily mean the stock market will decline going forward. Rather, what the January 1975 to December 1990 experience shows is this: Whenever the yield curve has flatten or inverted, the propensity to take risks significantly decreases, given that:
- Historically, commercial banks have played a significant role in providing liquidity and financing for domestic companies, and since banks traditionally borrow short and lend long - an inverted yield curve would deter them to significantly curtail borrowing and subsequently result in very tight credit conditions.
- Since the end of World War II and until recently, the nominal growth of the U.S. economy has had a great correlation with the yield of the long bond. When overnight interest rates exceed the yield of the long bond, this discourages companies and individuals to invest in stocks or in their own businesses. As the logic goes: If I can make more returns by putting my money into a savings account, why not do that instead of plowing into stocks or into my own business - when the latter create significant risks as well?
At various points in time, an inverted yield curve (signaling a propensity for risk aversion) will have a significantly adverse impact on the stock market - but the January 1975 to December 1990 experience does not show this was the case. Rather, what the above chart does show is that whenever the yield curve has inverted, credit conditions have tighten - which meant a severe "clampdown" on speculation in general. Specifically, this means that the markets that have risen the most quickly and that have attracted the most speculation will suffer the most once the yield curve is in the midst of inversion, such as the commodity markets in the late 1970s, a bank lending crisis in 1982 (accompanied by the worst recession in post World War II history), and the U.S. Savings & Loan Crisis in 1990 (not to mention the bankruptcy of many real estate investors such as Donald Trump). During all those times, the stock market was no doubt volatile - but please keep in mind that the stock market was affected disproportionately, given that (with the exception of 1987) domestic stock market valuations and speculation were not as high as, say, emerging markets or the real estate market. Case in point: Cash as a percentage of mutual fund assets was consistently over 8% in the 1980s, compared to a mere 4% today.
The second chart showing the January 1991 to the present experience tells somewhat of a different story - in that while the flattening or the inversion of the yield curve is still a leading indicator of higher risk-aversion going forward, the ensuing crises were somewhat different in character (and in geographical locations) than the experience from January 1975 to December 1990. Following is the weekly chart showing the differential between the yield of the long bond and the Fed Funds rate vs. the Dow Industrials from January 1991 to the present:
As the above chart showed and as I have mentioned, a flattening or inversion of the yield curve has usually resulted in a financial crisis somewhere in the world or in the United States. The $64 million question is: Where will the crisis occur? And how will that affect the U.S. stock market? Please note that while the Russian, Brazilian, and LTCM crises did not directly impact U.S. businesses, the subsequent risk aversion (which was foretold by the flattening of the yield curve starting in 1997) had a devastating short-term impact on the U.S. stock market - all the more given that the U.S. stock market was already overvalued at that point in time. Once the emerging markets were finally taken to the "cleaners" in 1998, speculation subsequently focused on U.S. and Western European stocks, specifically technology stocks. The flattening and subsequent inversion of the yield curve from early 2000 and onwards foretold the bursting of the technology bubble perfectly.
So where are we now? We know that both the Federal Reserve and the Bank of Japan has been tightening liquidity. At the same time, financial and commodity speculation remains rampant, signaling that "financial velocity" has been increasing significantly - which I have discussed many times before and which has been captured and measured by our MEM indicator. Increasing "financial velocity" basically means a higher willingness to take on risks - and with the proliferation of hundreds of hedge funds, lots of borrowed money, and subdued returns over the last two years, it is no wonder investors have taken on a lot of risks - probably more than what is prudent. Interestingly, however, the current flattening of the yield curve is telling us that "financial velocity" (willingness to take on risk) is about to decrease! Combined with a world of declining liquidity, then you have a recipe for disaster going forward. Again, the logical question to ask is: Which market will blink first? Will it be the U.S. housing market? Or will it be the base metals market or emerging markets? How about China - given its huge overcapacity in nearly everything from steel manufacturing to commercial real estate to automobile manufacturing? Note that U.S. money inflows and asset allocation to emerging markets are at their highest since 1994 - the year during the Mexico Crisis and the year before a huge down year for Latin American equities during 1995.
History has shown that a flattening or an inversion of the yield curve is usually a precursor to a financial crisis somewhere in the world - said target being an area (either geographically or a particular asset class) which has seen the most speculation prior to the inversion. While the forecasting significance of the yield curve may have lessened over the years (as we discussed in last Thursday's commentary), this does not mean we we should not be careful, unless one thinks that "things are truly different this time/" Moreover, while chances are that this "excess speculation" hasn't occurred in the U.S. stock market (except perhaps in U.S. mid caps and small caps), that does not mean any emerging market crisis will not impact the valuation of U.S. stocks in an adverse way - especially during a general "flight to safety" scenario similar to what occurred during the Fall of 1998. However, please keep in mind that it is this author's contention that we are still in a secular bear market in U.S. equities (similar to the secular bear market of 1966 to 1974) - and so despite a relative lack of speculation in the U.S. stock market in recent years (relative to the housing, commodity, and emerging markets), I would not be surprised if the inversion of the yield curve (decreasing risk-taking) is followed by a general liquidation of U.S. equities. I will now leave you with two more charts, which I have shown in a previous commentary (please feel free to discuss this in our forum or email me with questions):
Henry K. To, CFA