by Kevin Klombies, Senior Analyst

Wednesday, September 12, 2007

Chart Presentation: To Ease or Not to Ease

According to Goldman Sachs on Monday the odds of a 50 basis point reduction in the Fed funds rate next week were 97%. Following the October Fed meeting the odds were 99% that the funds rate would either be at 4.75% or 4.50%. In other words… the powers that be in the investment banking business are fairly confident that the Fed is ready and prepared to come to the aid of American home owners who, for one reason or another, purchased one or more properties that they evidently couldn’t afford.

A cynic, of course, might argue that this has more to do with supporting hedge fund returns and year-end investment banking bonuses for those who likely will never be in the position of defaulting on a mortgage… which brings to mind a line recently used by BMO Financial Group’s Don Coxe that ‘Capitalism without punishment is like religion without Hell’. At right is a comparison between platinum futures, gold futures, gasoline futures, and crude oil futures.

Each of these commodities reached price peaks in 2006 and each has taken a hard run at the highs during 2007. We mentioned in passing recently that we wouldn’t be surprised if gold futures jumped back to the 720 level just to make things interesting. Platinum took three good runs at the 2006 highs during the year only to fail on each occasion and earlier this year gasoline futures used the summer driving season and the never ending spate of unplanned maintenance shutdowns by refineries to lever back to just under 2.50. Now we find crude oil futures hammering at the highs even as OPEC members bicker about whether it makes sense to actually sell more oil at a higher price. We wish we had that problem.

In the spirit of the old line that it is a slow down if your neighbor is laid off, a recession when you become unemployed, and a depression when your spouse loses his or her job… we wonder whether the fervency with which Wall Street is arguing for easier credit conditions has to do with the fact that the problems are much closer to home this time around. The intriguing thing about the chart comparison at right is that energy and metals prices- which typically are the key driver behind the trend for short-term interest rates- are currently lined up in a most threatening manner.

Consider the Fed’s dilemma with regard to monetary policy if saving the banks, brokers, and hedge fund gazillionaires provides the spark that sends these major commodities to new highs next week.


Equity/Bond Markets

The chart at right compares the stock price of Bear Stearns (BSC) with that of Japan’s Mitsubishi UFJ (MTU).

The Nikkei began to under perform the SPX in the spring of 2006 while MTU’s stock price turned lower. Both trends are consistent with an underlying trend that favors lower long-term interest rates.We mention this because apparently the momentum traders in the U.S. markets failed to get the memo as they ramped the banks and brokers higher and higher. The chart argues, however, that the trend for BSC turned negative early in 2006 so all of the recent drama was little more than a stock and sector coming back ‘on trend’.

It wasn’t the end of the world or the beginning of never ending darkness so now that the dust has cleared somewhat we can see that both MTU and BSC are back at 2005 price levels. MTU just did it in a much more orderly fashion and without the accompanying UTube hysterics.Our sense is that the negative trend for the banks has more to do with flat or inverted yield spreads than it does with subprime mortgages although ultimately it is likely a chicken and the egg problem.

The trend turned negative in early 2006 when Japanese short-term interest rates began to rise. The chart below shows that 3-month euroyen futures declined over that time to reflect an increase in short-term Japanese yields from roughly .1% to .9%. That wouldn’t have been a problem, of course, if long-term yields were actually rising but now with 10-year Japanese yields at 1.53% it is little wonder that things are currently difficult- profit-wise- for Japan’s major banks.

So… this leads us to the chart below right of BSC and heating oil futures. The simple explanation is that rising energy prices applied upward pressure on short-term interest rates which, in turn, helped flatten the yield curve and ultimately bomb the banks and brokers. Another view might be that the banks and brokers were soaring so far off trend into the end of 2006 that something had to happen somewhere within the markets to bust the bubble and bring prices back to earth. Ultimately the markets are still going to have to figure out some way to widen the yield spread.