Lots of coverage this past week on the concern that the current Fed tightening cycle is going to end badly – as documented in my prior “The Macro View” dispatches.  Specifically,  there was lots of focus on the significance of the yield curve and it’s “inversion”. 


I thought it’d be useful to understand this important phenomenon, it’s causes, and more importantly what it portends for the future.  Excerpts from the article I’ve referenced –

People talk about interest rates going up and going down as if all rates moved together.  The truth is, the rates on bonds of different maturities behave quite independently of each other, with short-term rates and long-term rates often moving in opposite directions simultaneously.  What’s important is the overall pattern of interest-rate movement — and what it says about the future of the economy and Wall Street…..The yield curve is what economists use to capture the overall movement of interest rates (which are known as “yields” in Wall Street parlance).  Plot today’s yields for various maturities of U.S. Treasury bills and bonds on a graph and you’ve got today’s curve.  The line begins on the left with the shortest maturity — three-month T-bills — and ends on the right with the longest — 30-year Treasury Bonds…..From time to time, however, the curve twists itself into a few recognizable shapes, each of which signals a crucial, but different, turning point in the economy.  When those shapes appear, it’s often time to alter your assumptions about economic growth…..

Normal Curve : When bond investors expect the economy to hum along at normal rates of growth without significant changes in inflation rates or available capital, the yield curve slopes gently upward.  In the absence of economic disruptions, investors who risk their money for longer periods expect to get a bigger reward — in the form of higher interest — than those who risk their money for shorter time periods.  Thus, as maturities lengthen, interest rates get progressively higher and the curve goes up.

Steep Curve : Typically the yield on 30-year Treasury bonds is three percentage points above the yield on three-month Treasury bills.  When it gets wider than that — and the slope of the yield curve increases sharply — long-term bond holders are sending a message that they think the economy will improve quickly in the future.  This shape is typical at the beginning of an economic expansion, just after the end of a recession.  At that point, economic stagnation will have depressed short-term interest rates, but once the demand for capital (and the fear of inflation) is reestablished by growing economic activity, rates begin to rise.  Long-term investors fear being locked into low rates, so they demand greater compensation much more quickly than short-term lenders who face less risk.

Inverted Curve : At first glance an inverted yield curve seems like a paradox.  Why would long-term investors settle for lower yields while short-term investors take so much less risk ?  The answer is that long-term investors will settle for lower yields now if they think rates — and the economy — are going even lower in the future.  They’re betting that this is their last chance to lock in rates before the bottom falls out.

Reference : http://www.smartmoney.com/onebond/index.cfm?story=yieldcurve

BEARISH FORCES (Clearly on top)
More of the same – real concern in the markets that the Fed's desire to show it is on top of inflation might slow growth in the US CAUSED equities & commodities (both growth sensitive asset classes) to suffer substantial setbacks.  The argument here is that it takes 12-18 months for rate rises to affect the economy, and that the recent indications of rising inflation are in reality a lagging indicator – hence the Fed is likely to overshoot, causing a "hard landing".

BULLISH FORCES (Feeble and awaiting validation)
If the global economy is genuinely slowing due to higher interest rates, it should start to show up in weaker corporate profit forecasts.  The good news is this is not yet happening and if no such signs appear in the next few months, markets are likely to regain their poise.

2 dominant themes this past week that governed market dynamics –

  • The recent hawkish statements of the US Fed are raising concerns that the Fed may have gone too far and that the higher rates will eventually dampen growth.  As the FT puts it, "equity markets aren't concerned about inflation…they're concerned because the Fed is concerned about inflation.  What equity markets fear is a material loss in earnings momentum if the Fed continues to raise interest rates…"
  • Curtailment of the Bank Of Japan's zero rate regime is likely to have a big impact on Japansese sourced carry trade (the borrowing of cheap money in Japan for higher returns in emerging markets).  So far, we have witnessed $6b of outflows from emerging markets by US mutual funds alone.  Most analysts predict that the bottom is yet to come in this regard as hedge funds are still cutting their losses.

Counter weights were provided to keep the market in a "turtle" mode : slow moving, neither bull nor bear.  Hawkish comments from the US Federal Reserve CAUSED additional rate hike worries but weaker than expected manufacturing and jobs report figures BALANCED that out.

Significantly, a survey carried out by Goldman Sachs showed a strong consensus (70%) among market participants that it would not take longer than 6 months for the markets to regain their levels of May 10 '06. 

Volatility was the name of the game in equity markets worldwide this week. The volatility has come after a long period of calm. As the FT puts it aptly, "low volatility sows the seeds of it's own destruction, because it encourages investors to take on riskier positions, leaving them vulnerable to any changes in sentiment or in fundamentals." The "Goldilocks environment" of reduced inflation and stable economic growth has resulted in sustained low interest rates, leading to asset bubbles (technology, housing). Volatility was CAUSED BY :

  • US interest rate hike : investors need to be convinced that the US Fed is in control of the inflation situation. It will not help if the Fed is seen as "scared" to raise rates, even if the short term effect is lower rates. Bernanke is not inspiring confidence right now.
  • VAR (Value At Risk) models which dictate when large investors must bail out. The VAR models probably triggered simultaneoulsy, or near so, at most institutions as the models are all slight variants of one another. This probably caused a cascade effect resulting in the severe amount of market pull back witnessed.

Renewed US inflation scares dominated the market dynamics.  These concerns are based on a questioning of whether there can be a sustained rise in the economic growth rate without inflationary pressures.  The trigger was data showing a rise in US core inflation and it CAUSED :

  • Equity sell off
  • Dollar rally on expectation of rising US interest rates SUPPORTED BY
    • Eurozone political resistance to any further dollar fall

Dollar slid to its lowest level since Oct 1997 CAUSED BY :

  • Relative interest rate differential : Major economies (outside the US) signalled increasing interest rates (Banks Of England, Japan, & the European Central Bank).  Hence, what is refered to as the relative interest rate differential continued to move against the dollar.
  • The laser focus of the markets on the huge US current account deficit (7% of GDP) and the role that a weaker dollar will almost certianly have to play in order to bring this imbalance back to a more sustainable level. 

The dollar slide was INSPITE OF :

  • Fed's broadly hawkish monetary statement (more interest rate rises not ruled out)
  • Far better than feared US trade data

The dollar fall coupled with surgin commodities prices are both bad for the equity market.  The currency drop will hurt earnings of exporters, while the latter will add to inflationary pressures and hit corporate profit margins.  Hence, over the week, the DJIA was down 1% and the Nasdaq was lower 3.6%.