by Kevin Klombies, Senior Analyst,

We should probably start off by noting that even after yesterday the lows for the S&P 500 Index from this past Friday are still holding. Not, perhaps, that it matters of course.

We are going to change topics somewhat today and focus on the ‘driver’ behind the current equity markets problems. To make our point we are going to start with the chart at right of the Nasdaq Composite Index and 3-month euroyen futures from late 1999 through into the start of 2002.

Eurodollars are dollars denominated in a bank- often in London- outside of the U.S. Eurodollar yields represent the interest rate paid on these amounts. Similarly euroyen represents yen deposits in banks outside of Japan. Euribor represents the Euro Interbank Offered Rate and is the rate that one prime bank pays to another on euro deposits within the euro-zone.

In 1999 euroyen futures prices pushed up towards 100 which simply means that Japanese short-term interest rates were declining to very close to 0%. Yields held close to 0% into the spring of 2000 and the euroyen prices began to decline. The point is that the collapse of the tech and telecom sectors in 2000 went with a move up from 0% for Japanese interest rates. By the spring of 2001 Japan returned to the Zero-Interest Rate Policy (ZIRP) which helped to provide the world with almost free money through into early 2006.

Below right we show euroyen futures and the stock price of Japan’s Mitsubishi UFJ (MTU).

The point is that we can trace the start of downward pressures on the financials to the decline in euroyen futures prices around the end of 2005. In other words financial asset prices were ready and willing to rise- along with real asset prices- as long as Japan was willing to provide free credit. That makes sense to us. However, in both 2000 and post-2005 the trend towards higher Japanese interest rates went with tremendous downward pressure on the financial markets.

If MTU’s stock price turned lower in early 2006 and this coincided with the decline in euroyen prices as Japanese short-term yields moved upwards then we will assume that the start of the recovery for the financials will ultimately go with rising euroyen prices and falling Japanese short-term interest rates.



Equity/Bond Markets

Oct. 15 (Bloomberg) — Zuercher Kantonalbank, the Swiss lender that manages about $107 billion, said its gold vault is full after a surge in demand from investors seeking a haven during the credit crunch… Rand Refinery Ltd., the world’s largest gold refinery, in August said it ran out of South African Krugerrands. The Perth Mint, producer of 10 percent of the world’s bullion, doubled output in the past six months. Muenze Oesterreich AG, the Austrian mint, increased production of its Philharmonic bullion coin almost fourfold.

Below we show the ratio between MTU and the gold etf (GLD) along with 3-month euribor futures.

The basic trend from the end of 2005 to the present day has included downward pressure on the financials (MTU) and upward pressure on gold (GLD). The chart shows that this trend has also gone with declining euribor futures prices and Euro-zone interest rates moved upwards.

The point that we are trying to make is that- unfortunately- the markets appear unable to withstand rising short-term interest rates and are working very hard to persuade the Fed and the ECB that interest rates have to move lower. The chart below shows the CRB Index (commodity prices) along with an annual percentage Rate of Change indicator. While the ECB worries about rising inflationary pressures we note that the S&P 500 Index is down more than 40% year-over-year while the CRB Index is down roughly 16%.

Final point. In the spring of 2004 we argued that the Fed was holding the funds rate too low for too long and that the markets would force the Fed to raise interest rates by pushing energy prices higher. Today we have the opposite problem as the ECB holds yields too high for too long as the markets drive energy prices lower to show them the error of their ways.

Quickly… at bottom right we compare 10-year U.S. Treasury yields and the ratio between Johnson and Johnson and the S&P 500 Index. The argument is that the JNJ/SPX rises as long-term yields decline. The reality is that 10-year yields have jumped from around 3.4% to over 4% in a bit more than a week but… the JNJ/SPX ratio continues to climb. We still believe that yields are likely to move considerably lower.