Chart Presentation: Trend Shift

The chart at top right compares the Nasdaq Composite Index with the spread or difference between 30-year and 3-month U.S. Treasury yields between mid-1999 and the end of 2001.

The yield spread represents the difference between long and short-term interest rates. Since lenders tend to borrow short and lend long this spread represents their propensity to provide credit to fuel economic growth.

When the spread goes below the ‘0’ line- as it did during the second half of 2000- the yield curve has turned negative which leads to slower growth and reduced speculation. The argument is that the sharp rise in the Nasdaq through 1999 led to a gradual decline in the yield spread until it finally turned negative. Once the Nasdaq- along with capital spending- broke to the down side during the fourth quarter of that year the Fed began to lower the funds rate and the yield spread swung back to positive. Fair enough.

The chart at bottom right compares crude oil futures with the 30-year- 3-month yield spread from the start of the fourth quarter of 2005 through to the present day.

Through 2005 and into the summer of 2006 it seemed obvious that energy prices represented this cycle’s ‘Nasdaq’. The yield curve gradually moved lower as crude oil prices pushed beyond 75 and as the yield curve moved negative the trend for oil prices turned negative. Once again- fair enough.

The problem is and has been that as soon as the yield curve began to steepen crude oil prices reacclerated to the upside. Our thesis was commodity prices would peak in the spring of 2006- two years after the turn higher in interest rates in the spring of 2004- and continue to decline through the first half of 2008. Instead the markets shifted the burden of cyclical weakness from the commodity sector over to the financials so that each decline in short-term yields worked directly into ever higher prices for crude oil and gold.

Nine months or more after this shift we are still struggling with the nasty curve ball that the markets presented to us in 2007. For the sake of our mental health we would really prefer not to fight this trend for the next year or three so we thought that we should at least point out what the markets are doing even if we are having a hard time rationalizing the hows and whys of it.

The chart at top right compares the Nasdaq Composite Index with the spread or difference between 30-year and 3-month U.S. Treasury yields between mid-1999 and the end of 2001.

The yield spread represents the difference between long and short-term interest rates. Since lenders tend to borrow short and lend long this spread represents their propensity to provide credit to fuel economic growth.

When the spread goes below the ‘0’ line- as it did during the second half of 2000- the yield curve has turned negative which leads to slower growth and reduced speculation. The argument is that the sharp rise in the Nasdaq through 1999 led to a gradual decline in the yield spread until it finally turned negative. Once the Nasdaq- along with capital spending- broke to the down side during the fourth quarter of that year the Fed began to lower the funds rate and the yield spread swung back to positive. Fair enough.

The chart at bottom right compares crude oil futures with the 30-year- 3-month yield spread from the start of the fourth quarter of 2005 through to the present day.

Through 2005 and into the summer of 2006 it seemed obvious that energy prices represented this cycle’s ‘Nasdaq’. The yield curve gradually moved lower as crude oil prices pushed beyond 75 and as the yield curve moved negative the trend for oil prices turned negative. Once again- fair enough.

The problem is and has been that as soon as the yield curve began to steepen crude oil prices reacclerated to the upside. Our thesis was commodity prices would peak in the spring of 2006- two years after the turn higher in interest rates in the spring of 2004- and continue to decline through the first half of 2008. Instead the markets shifted the burden of cyclical weakness from the commodity sector over to the financials so that each decline in short-term yields worked directly into ever higher prices for crude oil and gold.

Nine months or more after this shift we are still struggling with the nasty curve ball that the markets presented to us in 2007. For the sake of our mental health we would really prefer not to fight this trend for the next year or three so we thought that we should at least point out what the markets are doing even if we are having a hard time rationalizing the hows and whys of it.