We are going to ease off on our positive dollar view for the time being simply because the euro is still holding above the 1.25 level.
At times in the past we have compared the current markets situation to 1982, 1990, and even 1998 and 2000. Today we are going to show how conditions are really quite similar- from a certain perspective- to 1998 following the Asian/LTCM/Russia/Brazil crises.
Beloware two charts of the CRB Index times the U.S. Dollar Index. The top chart is from July 1998 through June 1999 while the lower chart starts in July 2008 and runs through the end of last week.
It is common knowledge these days that commodity prices are stronger when the dollar is weaker- and vice versa. Dollar weakness tends to lend a bid to the commodity markets while dollar strength often serves to move commodity prices lower. While there have been many times in the past that the dollar and commodity prices have risen or fallen in tandem the recent reality has been that these two markets move in opposite directions- often on a minute-to-minute basis.
We will argue that the key for the trend for cyclical growth is not determined by commodity prices or the dollar but rather by the combination of the two. If, for example, the dollar rises 5% and commodity prices decline 10% in response… the trend for cyclical growth is negative. If the dollar falls 10% while commodity prices gain 5%… the trend for cyclical growth is still negative.
The product of commodity prices times the dollar declined into late 1998 before bottoming out just below 18,000. The same product declined into late 2008 before bottoming out… just below 18,000. In other words this is the second time in ten years that commodity prices adjusted for the value of the dollar have hit a major cyclical low at the exact same price and since we know that cyclical growth and the equity markets began to recover in earnest as we moved through the end of the first quarter of 1999 we are going to argue that, all things being equal, the light that we keep seeing off into the distance may actually be the end of the tunnel instead of an approaching train.
Equity/Bond Markets
One of our core beliefs is that an inverted yield curve leads to sharp slow downs in economic growth while a steeply sloped yield curve leads to economic expansion. We also believe that economic activity lags well behind changes in the yield curve.
Here is essentially how this works. The Fed raises the funds rate to slow the economy but nothing happens. They raise it again and again and again but still nothing happens. Finally they push short-term rates above long-term interest rates but the economy still appears robust. Why? Because changes in monetary policy today affect the economy anywhere from 6 to 24 months into the future.
Eventually the equity markets and then the economy collapse which leads the Fed to cut interest rates. Nothing happens. They cut them again and again and again and still nothing happens. Why? Because changes in monetary policy affect the economy anywhere from 6 to 24 months into the future. Rinse and repeat.
The chartbelow shows that the yield curve inverted during the second half of 2000 leading to a good 2-year hammering for the share price of Citigroup (C).
The chart below shows that the yield curve inverted in mid-2006 and the spread between 10-year and 3-month yields only began to rise during the first quarter of 2007. Once again… Citigroup’s share price was driven into a 2-year bear market.
The point? We are going to come at our point sideways today by showing a chart of 10-year Treasury yields (TNX) and the ratio between the Nasdaq Comp. and the S&P 500 Index (SPX) below.
If one reads and listens to the financial press it is obvious that the economy is deteriorating at an exponentially increasing pace. However… if that were true then why is the Nasdaq rising relative to the SPX? This only happens when cyclical growth is strong enough to push long-term interest rate higher. At the same time the yield spread began to improve 2 years ago so if the economy, the equity markets, and the share prices of the financials lag the yield spread… isn’t it likely that the real surprises later this year will be positive rather than negative?
