by Kevin Klombies, Senior Analyst

Monday, October 15, 2007

Chart Presentation: Post-Crisis

In the late summer of 1998 the relentless flight of capital away from the Asian, Latin, and emerging markets that had begun in 1997 with the peak in energy prices finally created a sense of crisis that culminated in a series of Fed rate cuts that eventually reduced the funds rate from a targeted level of 5.5% down to 4.75%. In response to this easing of credit conditions the NASDAQ 100 Index began to drive upwards. This forms the basis of today’s chart comparison.

The 1998-99 Asian/Russian/LTCM/Brazil crisis marked the lows for commodity prices, the commodity and Asian currencies, and the Asian equity markets. The point is that the actual crisis followed an earlier shift in the direction of the flow of capital away from Asia due to the perception or, perhaps, reality that better returns were available elsewhere. From this perspective the current situation is similar to 1998- in reverse.

The U.S.-based subprime mortgage problem would be appear to be the cause of the crisis but we suspect that this is merely the end result of the outflow of capital away from the dollar. Put another way as long as capital is flooding into a market or sector cracks do not appear. Turn the direction of the flow of money away from China for an extended period of time and we suspect that far greater problems would appear in its asset markets and banking system.

In any event the NASDAQ 100 Index (NDX) futures responded to the series of Fed funds rate cuts in 1998 by moving upwards with the initial rally lasting into late January of 1999. Once the Fed funds rate steadied out at 4.75% the pace of the advance in the NASDAQ slowed only to reaccelerate in October.

The NASDAQ did not reach a peak until March 2000. On March 21, 2000 the Federal Reserve finally moved the funds rate back to 5.5% so, in a sense, the ‘bubble’ began when the funds rate moved down from 5.5% and ended once the funds rate had returned to that level.

The initial reaction by the NDX futures this year to the cut in the funds rate is very similar to 1998 and through the end of last week the market was placing 75% probability on the funds rate being lower than today’s levels by the late January, 2008 Fed meeting and a 0% chance that it will be higher. If history were to repeat one or more cyclical markets have room to surprise to the upside until such time as the Fed finds reason to return the funds rate back to the 5.25% level.



Equity/Bond Markets

We very carefully worded our comment on page 1 that ‘one or more cyclical markets have room to surprise to the upside’ because we didn’t want to limit the potential to just the NASDAQ. History, after all, has the potential to repeat but in strange and often unanticipated ways.

The chart at top right compares the NASDAQ Comp. with the Nikkei 225 Index. The first point that we wish to make- aside from observing that the Nikkei is still showing the weakest relative strength (not a good thing, by the way)- is that these two markets trend broadly together. A trend that is positive for the NASDAQ will generally be positive as well for the Japanese equity markets.

The Nikkei has been the weakest of the major Asian markets as commodity prices have risen. In order to return to some semblance of relative strength we suspect that commodity prices would have to decline along with the equity markets of China, India, etc.

The chart below right compares the Nikkei 225 Index today with the NASDAQ Comp. back in 1998. The NASDAQ fell well below its 200-day e.g. line during the autumn of 1998 before swinging higher once credit conditions were eased. The trend remained positive, as mentioned on page 1, until the final quarter of 1999 at which time it swung from positive into ballistic.

Below we show the ratio between the NASDAQ and the S&P 500 Index (SPX) from 1998 into 2000 along with 10-year Treasury yields.

The idea here is that one of the features of this post-crisis trend was rising long-term interest rates. While the Fed did not return the funds rate to 1998 levels until the spring of 2000 the bond market reacted far quicker by moving 10-year yields up from under 4.5% to 6% by mid-1999. To the extent that a broad cyclical recovery has begun following the Fed’s return to easier credit conditions we would have to expect or at least watch out for higher long-term yields. This would obviously help to widen out the yield spread as the yield curve turns increasingly positive.