by Kevin Klombies, Senior Analyst,

The Asian crisis in 1998 helped push Japanese short-term interest rates down close to 0%. With the exception of a brief foray higher into 2000 Japan held a zero interest rate policy through into the end of 2005. One could argue that the current state of unrelenting crisis is, at least in part, a result of the removal of the major source of almost free global credit. In other words… now that the yen carry trade has come to an end with capital pouring back towards the yen… what will prove to be the replacement for Japanese ‘free’ money?

One rather obvious answer is shown at top right. The chart shows U.S. 90-day TBill yields. TBill yields are now effectively at 0% which suggests- somewhat disconcertingly- that the U.S. is in the process of accepting the mantle of the provider of ‘all you can want for nothing’ credit.

From our point of view this is sort of a good news/bad news proposition. On the one hand for monetary policy to be effective central banks have to be able to reduce the cost of credit below the prevailing level of inflation. If, for example, asset price inflation is rising at, say, 5% then a cost of funds of 1% creates a powerful incentive to borrow and invest. If asset price inflation is -5% then even 0% interest rates are ‘too high’. Economists tend to call today’s situation a ‘liquidity trap’.

The good news- and for this we have to stretch somewhat- would be that for a short period of time from late 1998 through into 2000 the Japanese stock market responded positively to 0% interest rates. At right we compare the S&P 500 Index from 1999 to the present day with the Nikkei 225 Index from 1989 through into 2000.

The idea is that the Nikkei’s peak in 1990 lines up with the 2000 peak for the U.S. equity markets. If so then 1998’s ‘crisis’- some 8 years after the Nikkei’s peak- corresponds to the SPX in 2008- some 8 years after the highs were set in 2000.

The point would be that while the Nikkei was most certainly not the dominant theme or relative strength leader from the autumn of 1998 into the spring of 2000 it did manage to rise by more than 60%. This raises the possibility or, perhaps, probability of a surprisingly strong asset-based recovery through into 2010 followed by another multi-year period of asset price decline. The challenge for us today is trying to figure out where the initial strength will appear and then, especially if the theme does not agree with our views, NOT argue with it for the next 12 to 18 months.




Equity/Bond Markets

Below we feature a chart of Alcan from mid-2005 into mid-2007. The argument has nothing to do with Alcan (which makes sense given that Alcan was bought out by Rio Tinto last year) and everything to do with autumn cyclical bottoms.

We have argued over the years that cyclical weakness into October tends to lead to strong recoveries into the following spring. Time and time again when cyclical asset markets crater into the fourth quarter they have tended to bottom and then turn higher. Such was the case for Alcan into October of 2005 and October of 2006.

The problem today is that all of the cyclical markets (commodities, Asian and Latin, tech, Japan, etc.) have declined into October. What we are looking for specifically is a sector that bottomed in October and is now set to push back above the 200-day e.m.a. line in a manner similar to Alcan in November of 2005 and 2006. The only candidate that we have uncovered- to date- is biotech. The biotech etf (BBH)- shown at right- made an October low and has moved back up to but not through the moving average line.

Below and below right we have included two comparative charts of the share price of Citigroup (C) and the spread or difference between 10-year and 3-month Treasury yields. The spread reflects the slope of the yield curve. At ‘35’ the yield for 10-year Treasuries is 3.5% greater than TBills.

We wish to show yet another detail from this chart. The stock market bottom in 2002 was made once the yield spread peaked and then turned lower so that it broke below the 200-day e.m.a. line. In other words… if history were to repeat… we would need to see 10-year yields declining well below 3.0% (more likely 2.5%) before stocks such as C would truly begin to recover in price.