by Kevin Klombies, Senior Analyst,

We were perusing an article published in 2006 by the Federal Reserve Bank of New York the other day. Not for light reading, of course, but because it dealt the relationship between inverted yield curves and recessions. The basic point is that since 1968 each U.S. recession has been preceded by an inverted yield curve although inverted yield curves do not necessarily lead to recessions.

The yield curve inverts when short-term interest rates
become higher than long-term interest rates. The Fed’s research suggested that the most predictable and reliable yields to use as a spread were 10-year U.S. Treasury yields and 3-month TBill yields so a negative or inverted yield curve would occur when 10-year minus 3-month yields move below zero.

Below we show the Nasdaq Composite Index and the spread between 10-year and 3-month Treasury yields from the start of the fourth quarter in 1999 through the first quarter of 2003.

The yield curve inverted at the end of July in 2000 a few months after the peak for the Nasdaq. The ensuing asset price decline represented by falling equities ran through into October of 2002.

And we feature a chart of the CRB Index and the 10-year minus 3-month Treasury yield spread.

The yield curve inverted in July of 2006 a few months after the CRB Index reached a top.

In a past issue we commented that the current cycle is somewhat strange in that the asset group that pushed interest rates higher (Nasdaq in 2000 and commodities into 2006) was not the same asset group that was pulling them lower. The problem was that aside from the intense nature of the banking system crisis that was how it is supposed to work. When Greenspan held rates too low for too long the commodity markets drove rates higher. Now that the ECB is acting out the role of Paul Volcker and holding rates too high for too long it should be the commodity markets that do the work to pull them back to the down side.

Our point? If the bottom for the negative asset price cycle is due this month then the CRB Index has to get busy. From our point of view this suggests at least the potential for even greater commodity prices
declines over the next few weeks.



Equity/Bond Markets

In yesterday’s issue we included a comparison on the back pages of the yield spread and the share priceof Citigroup (C). The argument was that if the ‘time’ between the inversion of the yield curve and the bottom for the financials (i.e. Citigroup) was the same as 2000- 2002 then C should have made a bottom in September. Fair enough.

Today’s first page argument was pointed towards potential commodity price weakness so we will attempt to show how we got from ‘here’ to ‘there’.

If Citigroup has bottomed then the chart at top right suggests that gold has peaked. In fact the chart argues that it was weakness in C that pushed gold up above 700. Simply put… the better C does the greater the pressure on gold prices.

Below right we show the CRB Index and the ratio between FreePort McMoRan (FCX) and JPMorgan Chase (JPM).

The chart makes a rather intriguing point. The equity markets have gone significantly further than the commodity markets in correcting the post-2004 excesses. Keeping in mind that commodity prices broke upwards in 2004 because the Greenspan Fed held interest rates ‘too low’ for too long (that was exactly our argument in the spring of 2004 by the way) we will argue today that the Trichet ECB is making the same mistake in reverse by holding rates ‘too high’ for too long. In the mean time the FCX/JPM ratio has corrected all the way back to the levels of 2004 while the CRB Index is still 10% to 15% above those levels.

So… will the CRB Index decline back towards 285? We do not know. Could it decline to 285? Absolutely. Why is it still so strong? Crude oil prices. The FCX/JPM ratio closed below the lows of January 2007 yesterday and in January of 2007 crude oil prices declined close to 50. If there is going to be a break it really should be in energy prices.

Finally the chart below shows the ratio between the CRB Index and the S&P 500 Index (SPX). We have argued from time to time that this ratio ‘should’ snap back down towards .22:1. We have also argued (and will do so again today on page 5) that this will lead to weaker commodity prices and stronger equity prices. Tempering our expectations back a bit the CRB Index at 286 and the S&P 500 Index back up to 1300 would fit the argument perfectly.