December 28, 2005
More on the Yield Curve - It's Implications
December 28, 2005
Yield curve focus, Wed., Dec. 28, 2005, 8:35 AM
There are two aspects of bond yields that traders must keep in mind. One is the level of yields, which I see as a reflection of how much capital there is in the world seeking a reasonable risk-adjusted return, and the other is the slope of the yield curve, which I see as being an indicator of economic health. These are separate but not mutually exclusive concepts.
A country’s central bank and Treasury administration works together to (i) maintain stable financial and capital markets, (ii) act as key money facilitator of government operations, and (iii) be an important instrument of the Administration’s political policies.
For many years in the U.S., until George Bush became President in 2000, the Federal Reserve Bank was able to keep a fair distance from the White House. But, whether by design or by events related to international terrorism and natural disasters, it is clear today that politics and central banking are fused.
Some argue that this mixture is like oil and water (no pun intended), and should be kept apart like Church and State (again no pun intended). As I see it, there is no longer a benefit to maintaining separation between the Fed and the Treasury because the Fed now operates mostly in the short-term.
I wonder if anybody has ever seriously considered having Congress elect a Fed head for six-year terms that would offset the four-year Presidential cycle (and the appointment of the Treasury head).
In any event, due to the size of the bond market, neither the Treasury nor the Fed can manage the long-term bond yield as well as they can and do the short-term rates. In fact, in just five years, the bond market has grown so huge, and the percentage of U.S. Treasury debt in the control of foreign traders (now over 50 pct versus one-third in 2000) that I believe U.S. monetary policy is out of control, i.e., it can no longer be used as an effective control mechanism.
So, with respect to the yield curve, I now believe that international financial and capital markets are in control.
What does that imply? For one, the occupant of the White House is no longer the master of his domain. From this point forward, whenever financial and capital market risks, and opportunities for creating wealth, warrant the re-investment of foreign capital into their own domestic economies, foreigners will sell their holdings of U.S. debt. And the moment that begins to happen, the U.S. bond market will fall, and rates will rise.
And if the U.S. economy happens to fall into recession, where turnover of the money supply falls, and money becomes scarce, the short rates will rise faster than long rates.
I suspect that 2006 will see the first recession in the U.S. since foreigners have gained control of the U.S. bond market. Should the economies of Asia/Pacific and Latin America regions continue to grow strongly, I believe that the USD will come under extreme pressure, and the Treasury and Fed will have no option but to reflate. In fact I think they started this process in September.
Such a move makes U.S. bonds relatively more attractive than equities, and gold more attractive than USD.
As I say, I think the process has started, and the scorecard will be the Living Yield Curve.
To reiterate, the flatter the curve, the more attractive bonds will be relative to equities. The higher the level of rates, the less attractive bonds become, but the more risky equities become (average PE multiples will fall). In both cases, gold will out-perform.
As traders come to realize what I am saying has currency, the price of gold has been rising. In fact, gold today is up a further $5.50 to this point. It is now at $515.50 on the Feb-06 contracts.
Where gold will under-perform is when the living yield curve begins to slope back to normal, where long rates are significantly higher than short rates, because that will imply that real wealth is being created, and that assets should be allocated to those processes rather than let sit unallocated in cash or gold.
One other point, which you have seen me making for some time in going short U.S. financial stocks versus long the gold sector. a U.S. recession -- regardless of reflation -- will hurt the profitability of commercial bank and mortgage lenders. Make no mistake about that.