by Kevin Klombies, Senior Analyst

Wednesday, September 19, 2007

Chart Presentation: Under Trend

Quick summary. The Fed cut the funds rate and discount rate by 50 basis points, equities exploded to the upside, and the U.S. dollar tanked as crude oil made new highs. That about covers yesterday’s news so let’s move on to today’s Chart Presentation.

One of our views is that the underlying direction for short-term U.S. interest rates is a reflection of the trend for the Australian dollar futures. If the commodity-sensitive AUD is strong and rising then interest rates should also be moving higher and when this currency is tunneling lower the Fed should be making effort to ease credit conditions at every opportunity.

The chart at top right compares 3-month U.S. TBill yields and the AUD from 1996 into 2002. From roughly the end of 1996 through 2001 the trend for the Aussie dollar was clearly lower.

The point is that for much of this time period the Fed was attempting to fight inflationary pressures that were, we suspect, nonexistent. The Asian crisis in 1998 along with the melt down in the tech and telecom sectors through 2001 helped persuade the Fed to lower yields back to the underlying trend defined by the path of the AUD.

We mention this because the current situation is almost the exact opposite. The AUD turned higher in early 2002 and for more than 2 years the Fed held interest rates well below trend. Eventually the commodity markets helped show the Fed the error of their ways as energy and metals prices exploded to one new high after another. By the spring of 2006 the CRB Index finally peaked the short-term yields moved back below the ongoing rising trend.

We understand the Fed’s concern for the health and well being of the global credit markets and if we have learned one thing this week it might be never to argue with the interest rate views of Goldman Sachs. GS recently changed it forecast to a Fed rate cut of 50 basis points so while the size of the cut may have surprised the markets it fit nicely with the expectations of GS.

Our point is that for as gloomy as the markets may have felt only a day or two ago there is nothing particularly bearish about short-term interest rates holding well below ‘trend’ this late in an economic cycle. In fact, we suspect that it is bullish enough to drive the S&P 500 Index to new highs in very short order.



Equity/Bond Markets

Each time we look at a chart of China South Airlines (ZNH) we wonder what in the world is happening. The more we pondered the problem the more we became convinced that it had something to do a market holding well below ‘trend’ for an extended period of time. As we put together comparisons it occurred to us that this very simple perspective might help explain a great many things ranging from the strength in crude oil to the take overs of both Alcan and DaimlerChrysler.

The chart at right compares ZNH with Canada’s WestJet (WJA), Intel (INTC), and Caterpillar. Below right we show DaimlerChrysler (DAI), and the Hang Seng Index from Hong Kong while below we show Ford (F) and AMR.

The argument starts with the observation that the bullish or positive equity markets trend began around the autumn of 2002. Many stocks and sectors rallied briskly up from the 2002 lows only to run out of steam in early 2004 when the markets began to focus almost exclusively on the energy and metals sectors. Still, we can show any number of charts (Bank of Nova Scotia and Boeing come to mind) of stocks that have simply held the rising trend from 2002 to the present day.

The strength in ZNH since May swings it up ‘on trend’ in a manner quite similar to the trend for DAI earlier this year and the way Alcan was driven higher by yet another take over. It explains why AMR was so strong through the end of 2006 and why IBM continues to push upwards.

This is an extremely bullish perspective and, perhaps, one that helps explain how the U.S. equity markets could snap so sharply higher on a Fed rate cut that has been widely anticipated for weeks.

The true ‘wild card’ stocks now would have to be Ford (below) and perhaps Intel and Cisco. We have no idea how the markets will eventually get this done but it does offer a bit of hope for stocks like Mitsubishi UFJ (potential into the 20’s) and Matsushita (may be a double from current levels). If the day comes when WestJet actually trades up through 40 even we will sit in awe of the markets.