In a recent Goldman Sachs economic report (Global Economics Weekly, Jan. 13, 2010) the concept of ‘twin peaks’ was discussed. The idea intrigued us to the point where we spent some time attempting to put it into a frame work that we could work with from an intermarket perspective.
The ‘twin peaks’ represent two U.S. employment-related events. The first is the peak for initial jobless claims. This marks the bottom or worst point for growth. When initial jobless claims reach a peak- as they did in March of last year- the markets begin to bid the price of equities and risky assets upwards.
The second event is the peak for the unemployment rate which is generally associated with the point in time when the U.S. economy is able to resume above-trend growth. When the employment rate begins to decline the yield curve tends to flatten as short-term yields rise.
Historically the time between these two peaks has been fairly short (i.e. a matter of a few months). In recent cycles, however, the time has expanded to a year or two. Based on Goldman’s view that the employment rate will not begin to improve until some time towards the middle of 2011 the argument is that we will remain between the ‘twin peaks’ for some time.
Below we show the S&P 500 Index (SPX) and the spread between 10-year and 3-month Treasury yields from 2003- 2004. If the bottom for the SPX in the spring of 2003 represents the first peak while the initial decline in the yield spread in May of 2004 represents the second… then our sense is that the SPX is likely to grind upwards with repeated tests of the 50-day exponential moving average line. When this moving average line is eventually broken- as it was late in the first quarter of 2004- then the equity markets trend will shift from positive back to… corrective. Fair enough.
At bottom is a comparison based on the current situation. As mentioned above the first peak associated with the trough for growth was reached in March of this year at the very bottom for the S&P 500 Index. If the peak for the unemployment rate is set for some time in 2011 then the present trend is somewhat similar to the 2003 example. The SPX would be expected to make dramatic tests of the moving average line (similar to last week’s) until one of the sharp recoveries ultimately fails. How this relates to the Japanese stock market is another matter; one that we will expand on through the balance of today’s issue.
Equity/Bond Markets
We don’t differ with Goldman Sachs’ work as much as we approach the topic from a different direction. Their argument was that the yield curve begins to flatten when U.S. growth improves to the point where the ‘jobless recovery’ begins to generate enough jobs to turn the employment report lower.
Our view back in 2004 was that rising energy prices would serve to push short-term U.S. interest rates upwards.
Below we feature a comparison between the Fed funds target rate and heating oil futures. In mid-2004 heating oil futures finally broke to new all-time highs. Growth had improved to the point where the demand for energy apparently justified much higher prices. As heating oil futures pushed higher the Fed funds rate began to rise which, in turn, initiated the process of flattening out the yield curve.
As we worked through all of this we wondered how this might relate to some of the other markets and themes that we have been working on. When we are between the two peaks representing the bottom for growth and the eventual pick up in aggregate U.S. demand that goes with rising short-term interest rates… what, if anything, works as a theme?
One idea that seemed to make sense to us is Japan.
The premise is that the Japanese stock market only does well when Japanese bond prices are falling. Put another way as long as Japan’s economy is so weak that long-term interest are falling the Nikkei will tend to underperform most of the major global equity markets. Japan tends to shine when the Japanese bond market reaches a peak and starts to decline.
At bottom we show the same chart as above except that we have added in the Japanese 10-year (JGB) bond futures. The chart covers the time period between the spring of 2003 and the autumn of 2004.
The chart above showed that the S&P 500 Index began to rise in March of 2003 although the Japanese bond market did not rise to a peak until roughly one quarter later. By June of that year the JGBs peaked and turned back to the down side.
The declining trend for Japanese bond prices continued through the balance of 2003 into June of 2004 reaching bottom right around the time the Fed initiated its first increase in the Fed funds rate. The argument would be that the markets would or could move through a sequence of sorts with the U.S. equity market turning higher at the peak for jobless claims- an event that took place in March of 2009- followed in due course by a return to strength by the Japanese equity market once Japanese bond prices began to trend lower.
If history were to be kind enough to repeat the trend would extend through until the Fed was ready to start tightening credit conditions following an improvement in the U.S. labor situation. To the extent that many feel that the current output gap is sufficiently large enough and deep enough to keep the Fed on hold until some time in 2011 it appears that there is a window of time available for better performance from Japanese equities.
