A causal relationship exists when one event (cause) necessarily leads another event (effect). We will argue that causal relationships exist within the markets but often with such a lag between the cause and effect that by the time the inevitable occurs one tends to have forgotten why it necessarily had to happen in the first place.
Our point today revolves around inversions of the yield curve.
Prior to the current situation the yield curve inverted (short-term yields rose above long-term yields) ahead of each of last six U.S. recessions. We wrote about this quite often through 2006 as the yield curve once again moved towards inversion arguing that this meant that economic growth would necessarily slow. The cause- an inversion of the yield curve over a multi-month time period- led to the effect- a recession.
The problem is that the lag between yield curve inversion and its impact on economic growth is so extended that most tend to forget that what is happening today is the result of something that transpired several years earlier. The good news, on the other hand, is that the argument cuts both ways. If a negative yield curve precedes recessions then a sharply rising yield spread leads to recoveries.
Below we have included a comparison between the yield spread or difference between 10-year U.S. Treasuries and 3-month U.S. TBills and the S&P 500 Index. The charts have been shifted or offset by close to 2 1/4 years.
The idea here is that the stock market’s bottom in late 2002 into early 2003 was the result of the yield curve’s inversion through the second half of 2000. In other words once the yield curve went negative in 2000 economic growth and asset prices did not bottom for more than two years.
In terms of the current time frame this would suggest that the initial lows for the S&P 500 Index made last autumn were the result of the yield curve moving to inversion in the summer of 2006. The argument also suggests that the process of working through a stock market bottom should run from last October through the second quarter of this year only to be followed by a broad and sustained recovery for economic growth that, we suspect, will last for several years. The good news is that the economy and the stock markets will surely recover while the bad news might be that it will probably be some time closer to July before the trends swing back to positive.
One of the key arguments for the past year or three has revolved around the idea of ‘offsets’. In general we were looking for the U.S. dollar and Japanese yen to rise as an offset to capital outflows from the BRIC theme, for large cap markets and stocks to outperform smaller cap, for consumer and health care to rise relative to commodity cyclical, and for the U.S. and Japanese stock markets to do better on a relative basis.
In general… our views and arguments have worked out nicely- at least on a relative basis. The problem has been that no matter how hard the commodity sectors get pounded investors just can’t seem to grasp the idea that the winners from the last cycle are typically not the leaders for the next cycle.
The argument is that as the dollar rises Brazil should weaken relative to Japan. Similar to the strength in the commodity currencies, the Chinese stock market, and copper prices the markets appeared intent on viewing the correction in commodity prices as a simple correction instead a cycle-ending event. If our views are correct- and wouldn’t that be a pleasant surprise- the Japanese stock market should continue to outperform.
Quickly… the ratio between the Morgan Stanley Consumer Index and Cyclical Index broke to new highs yesterday. What the markets need is leadership and our view is that it is supposed to come from the consumer stocks.
The bond market was sharply higher yesterday as Micron (MU) bent lower from its 200-day e.m.a. line. For good or for bad we are going to hold to the view that the TBond futures peaked in December of last year. It will very likely take new highs for the TBonds or 10-year Treasury yields sub-2.0% to make us change this view.