by Kevin Klombies, Senior Analyst

Friday, December 21, 2007

Chart Presentation: LAGS

We are always fascinated by the way the markets seem to forget that when a central bank is intent of slowing or accelerating economic activity… they do so. Each time the Fed embarks on a rising interest rate trend as an offset to cyclical strength the economy slows and each time the Fed pulls interest rates lower in an attempt to stimulate economic activity a recovery follows. The problem is that monetary policy works with such a long lag that investors are lulled into thinking that this time is different. It never is.

The relationship between interest rates and commodity prices works on two different time frames. In ‘real time’ interest rates rise and fall with commodity prices but the impact of rising or falling interest rates works on commodity prices with a considerable lag. We have argued that the lag is very close to two years.

The chart at top right compares 3-month eurodollar futures from 2004 with the CRB Index from 2006.

The argument is that the decline in eurodollar futures prices which represents the start of rising short-term U.S. interest rates in 2004 served as an offset to rising commodity prices in real time and also forecasted the eventual peak in commodity prices in the spring of 2006.

The twist is that the creation of the Euro-zone and the European Central Bank created a second monetary authority powerful enough to rival the Fed. While U.S. interest rates turned higher in the spring of 2004 the ECB did not begin to tighten credit until the autumn of 2005.

Our argument has been that this helps to explain the second ‘top’ in the commodity markets. The first top in 2006 was created by rising U.S. interest rates in 2004 while the second top in the fourth quarter of 2007 was a reflection of the turn upwards in European yields in 2005.

A similar argument can be made with respect to China. The Bank of China has raised interest rates six times this year and will continue to do so until the Chinese equity market buckles. Investors- as always- will be shocked and surprised to find that a sustained period of increased credit costs and reduced credit availability can actually impact real economic activity.





Equity/Bond Markets

The chart at right compares the Fed funds rate and the stock price of Intel (INTC) from 1999 into 2001.

Commodity prices are only one of a number of sectors that tend to swing with cyclical growth. Typically commodity prices dominate the trend when the dollar is weaker while tech is relatively stronger during those trends that include a stronger dollar.

Interest rates were driven higher into 2000 in large part by cyclical strength in the tech and telecom sectors. When INTC’s stock price finally peaked and turned lower it marked the end of Fed tightening and the eventual start of lower interest rates.

In the current cycle interest rates were being pushed upwards by strong Asian growth and rising commodity prices. Even as the financial sector implodes in response to what is in effect a relatively small decline in U.S. real estate prices the European Central Bank is still as or, perhaps, more concerned about the prospect of inflation than the reality of a credit markets crisis.

In any event the rising trend for Intel that began in 2006 occurred at the peak for the Fed funds rate and the sum of copper and crude oil futures prices.

Both Oracle and Research in Motion produced better than expected earnings this week as the tech sector improves in response to lower interest rates. To some extent the chart of Intel from mid-2006 forward appears similar to the U.S. home builders following the NASDAQ’s peak in March of 2000. If history repeats tech should do very nicely through the first half of 2008.