by Kevin Klombies, Senior Analyst

Tuesday, June 5, 2007

Chart Presentation: Themes

For many months we argued that the key to turning the beleaguered Japanese banking stocks higher (MTU in particular) would be new highs for the ratio of Japanese equities to Japanese bonds. The idea was that Japanese equities (Nikkei 225 Index) tend to rise when there is sufficient cyclical strength in Japan’s economy to push long-term interest rates upwards and a rising trend for interest rates in Japan would help widen the spreads and hence of the profitability of the major banks.

The problem was that when the ratio finally broke to new highs last February the Chinese stock market began to decline and this weakness spread throughout the global markets forcing the Nikkei/JGB ratio rapidly lower.

We show, from bottom to top, the Nikkei/JGB ratio, Hong Kong’s Hang Seng Index, the S&P 500 Index (SPX), the euro futures, and 10-year U.S. Treasury yields.

Last February as the Nikkei/JGB ratio pushed to new highs the euro futures were at a short-term low while 10-year Treasury yields had risen to 4.9%. Typically a weaker euro goes with downward pressure on metals prices while rising interest rates a negative for equity valuations.

A few days after the Nikkei/JGB ratio broke higher the Hang Seng Index and S&P 500 Index began to decline along with long-term Treasury yields while the euro turned upwards.

The argument is that the equity markets in February were rising based on a strong commodity price theme. The combination of higher interest rates (negative for equities) and a weaker euro (negative for commodity prices) created pressure on the major equity indices which in turn sold off sharply. As soon as the equity indices began to weaken, however, the markets removed the pressures by pulling 10-year yields back to 4.5% and swinging the euro higher to help support metals prices.

The point is that if the only game in town is commodity price momentum then euro weakness will eventually be a negative for equities. One of the key features of the start of the decline in energy prices last summer was strength in the telecom sector but we have yet to see the kind of positive surprise in a non-commodity heavy weight that would support our contention that the markets are ready, able, and willing to push upwards in the face of falling energy and metals prices.


Equity/Bond Markets

The chart compares the yield index for 10-year U.S. Treasuries (TNX) with the Morgan Stanley World ex-USA Index. The ex-USA index represents- as one might expect- the trend for non-U.S. equity markets.

The charts are virtually identical which makes the point that the driver for long-term U.S. yields is not domestic inflation or employment but rather the trend for global growth.

The argument would then be that as long as this index is making new highs the underlying trend for long-term U.S. yields is also higher.

Below right we show the stock price of Boston Scientific (BSX) and 1-month LIBOR futures. 1-month LIBOR futures trade at a discount to 100 so a price of 99 denotes an interest rates of roughly 1% while a price of 95 would represent a yield of close to 5%.

The argument has been that BSX trends with short-term debt prices so it makes sense that as LIBOR prices have flat lined since the summer of 2006 the trend for BSX has also been flat.

If the trend for long-term yields is higher while the trend for short-term yields is no better than neutral the argument would then be that the yield curve should rise as the spread between long and short-term yields widens. That is exactly what has been happening (chart below) since early March with the stock price of Fannie Mae (FNM) trending with the yield spread.