by Kevin Klombies, Senior Analyst

Tuesday, June 19, 2007

Chart Presentation: Duration

From many perspectives the markets appear to be ‘business as usual’ with much of the speculative fervor concentrated in the commodity sectors. The Chinese equity market sold off sharply several weeks ago but has since recovered with Hong Kong’s Hang Seng Index pushing to new highs. Gasoline futures prices remain strong as the major refiners take turns shutting down for unplanned maintenance and the Japanese yen moves lower daily now that the Bank of Japan is apparently on hold until at least August.

On the other hand… here and there within the markets there are some very strange cross currents.

The chart at top shows the Fed funds target rate and 3-month eurodollar futures from the summer of 2000 into the spring of 2001. What we are attempting to show is how the Fed follows the market at important turning points. In other words when the Greenspan Fed slashed the funds rate at the start of 2001 it did so because the market said that there was a problem. Towards the end of November in 2000 the price of 3-month eurodollar futures began to rise as money started to aggressively move away from risk and towards safety.

Below we show the Fed funds target rate from the current time frame and 3-month U.S. TBill yields.

We admit that there has been no discernible change in eurodollar futures prices but would point out that a widening of the TED spread (the yield difference between TBills and eurodollars) is often associated with an impending financial crisis. What we can see on the chart is a rapid decline in short-term interest rates even as long-term interest rates have risen. The net effect is a rather impressive widening of the yield spread between 10-year and 3-months Treasuries which we have pointed out in previous issues typically goes with the start of a serious decline in one or more cyclical asset markets (i.e. copper prices).

At minimum capital is fleeing duration by selling long dated bonds and buying short-term. It is possible that this storm will pass as metals prices and Asian equities firm up and as the U.S. dollar weakens off to reflect the resumption of the flow of money into the smaller and more commodity sensitive regions. It is also possible that what we are viewing today is the leading edge of an emerging crisis that, in the fullness of time, will seem perfectly obvious given the dramatic decline in TBill yields.



Equity/Bond Markets

We show charts of the S&P 500 Index from 1987, Hong Kong’s Hang Seng Index from 1997, and China’s Shanghai SE Composite Index from 2007.

Just because there was a serious markets ‘crash’ in 1987 and an almost identical collapse ten years later in 1997 does not mean that we can expect a repeat in 2007. Just because the SPX peaked in August 1987 and the Hang Seng peaked in August of 1997 with both markets breaking sharply lower in early October does not mean that the same thing will happen this year. On the other hand…

The SPX and Hang Seng charts show the time frame from January through November while the Shanghai chart has been shifted by roughly a month and a half so that it starts in mid-October of last year. The reason we did this is because the SPX and Hang Seng went through a correction into April that led to a ramp higher into August while the Shanghai market may have made a similar correction this past February.

We are attempting to make two points here. First, that in both 1987 and 1997 pressure built leading to the collapse of one or more major equity markets. A number of months before the final peak there was a sharp correction that resolve to the upside. Second, it is possible that the Chinese equity market is already working through the second and final top.

Below we feature two charts of Fannie Mae (FNM). The top chart is from the 2000 time frame leading up to the first Fed rate cut in early January 2001 while the lower chart is from the present period.

We can’t help but notice that FNM is still trending as if it was somewhere in the fourth quarter of 2000. TBill yields are falling rapidly and FNM does better with a widening yield spread. That may be the simple answer but… even so… we do not have to stretch too hard to make a case that this may be anything but ‘business as usual’.