One of our basic views is that the direction of the trend for yields serves to define the health of the cyclical theme. In other words when yields are rising money tends to move towards the economically sensitive sectors while when yields are declining money tends to migrate towards more defensive and stable sectors.
The trend for the U.S. dollar helps to further define the cyclical theme. When the dollar is moving higher along with yields the focus of the markets’ attention tends to be on the financials and techs. When the dollar is falling while yields are rising strength tends to show up in the basic materials and energy sectors.
On any given day the markets can do almost anything but over time trends become somewhat more clear. To explain what we mean by this we have included a chart at top right of the sum of the U.S. 30-year T-Bond futures and U.S. Dollar Index (DXY) futures along with the combination of copper futures (in cents) and crude oil futures (in dollars times 3).
The argument is that at the end of last September the sum of the TBond and DXY reached a peak. This was the point in time when the markets began to shift from a defensive posture over to a more aggressive trend. As the sum of the price of the TBond and Dollar Index started to flatten out the sum of copper and crude oil pivoted back to the upside. Close to four months later nothing much has changed.
Below right is a comparative view of the ratio between gold futures prices and 10-year Treasury yields along with the ratio between the Bank Index (BKX) and S&P 500 Index (SPX).
The point is that from the end of last September through trading yesterday the best that we can argue is that things haven’t gotten worse. Bond prices have stopped rising and the dollar, which ended the third quarter of 2011 around 80 is virtually unchanged. The initial reaction to things ‘not getting worse’ has been strength in energy and metals prices while at the same time we can also see that the Bank Index is showing marginal strength versus the SPX as the bullish trend for gold prices moves into a sideways holding pattern.
If bond prices continue to weaken then the next challenge is to get a reasonable sense of whether the U.S. Dollar Index is going to rise or fall from the 80 level.
We will come back to the U.S. Dollar Index on today’s third page but for now we wanted to show a longer-term argument as we search for perspective.
Below is a chart of the yield spread or difference between 10-year and 3-month Treasuries.
The yield spread helps to show the ‘slope’ of the yield curve. When the spread is ’20’, for example, it means that 10-year yields are 2.0% greater than TBill yields. Whenever the spread is greater than ‘0’ the yield curve is positively sloped which tends to be economically stimulative.
The argument is that the time to really worry is when the yield spread moves below the ‘0’ line. There have been two major cyclical tops in recent years- 2000 and 2007- and both were associated with inverted yield curves.
At top right is a chart of the sum of copper and crude oil futures from 2000 into the autumn of 2001.
We could have used something like the Nasdaq or S&P 500 Index because both peaked in 2000 but thought that we would show something a bit less obvious. The yield spread moved below ‘0’ in July of 2000 just ahead of the top for energy and base metals prices.
The chart at middle right shows the Bank Index (BKX) from 2006 through 2007.
The yield spread went negative around the end of July in 2006 and remained below the ‘0’ line through May of 2007. The chart makes the case that the inversion helped mark the peak for cyclical asset prices through that time frame.
The point is that the yield spread is nowhere close to the ‘0’ line and unless 10-year yields find some way to decline to or below 0% we aren’t likely to see an inversion for another couple of years. We argued in yesterday’s issue that once long-term yields start to rise the Fed won’t typically raise the funds rate for another 9 to 12 months and, even then, it could take at least another year or two of hikes to move short rates back above long rates.
