BigTrends

I recently received this question about the BigTrends 2010 Outlook that I would like to share along with the answer:

"Bob, I am trying to understand the corelation of bond rates and the effect that has on equities. I am hoping you can put this in laymans terms, please. Thank You xxxxxxxxx"

Thanks for your question.  I'll do the best I can to make this seem simple. 

There are different ways bonds and equities interact with each other in markets.  The most basic tenet is liquidity or money flow.  Let's pretend for a minute that there is a limited amount of capital in the system (I say pretend because the printing presses run hard everyday).  The search for yield is constant, but also must be balanced by risk tolerance.  An investor would like a given amount of return for a far amount of risk taken. 

So, where should that capital be deployed?  In most cases it's a choice, or even an allocation to either/or.  Since equities have a higher beta (risk) than bonds, you have the following:  If you desire less risk, you put more into bonds, less into equities.  More risk, vice versa.  Capital flows back and forth.  A strong bond market though, with money flowing into it is good for stocks, too.  How?  borrowing costs, costs of capital are lower which means more to the bottom line.  

I spoke recently about the yield curve and its importance.  The desire for an upward sloping yield curve is attractive to equities as it portrays growth (good productivity means it's not inflationary)...too steep and it's probably inflationary.  We have not had consistently good growth for a couple of years.  The Fed wants to see a steeper curve before it raises rates, even more they want to see good GDP numbers before they act.  What does an upward sloping yield curve represent?  If you lend your $$$ out longer you should be compensated better, with a higher rate. 

How do you shift the curve?  It needs to be whipped from the bottom (fed funds rates) or the top (10 year or longer).  Draw a yield curve on a line chart and you'll see it (upward sloping, left to right).  An inverted curve is not positive and is recessionary.  Further, we also watch spreads between riskier bonds (corporates) and treasuries to make sure there is no disconnect of historical risk.   So, the answer is low rates are good for stocks, but falling yields will take away from equities due to risk aversion.

The last (maybe) version of the 3Q GDP is out and it appears to be a bit less than expected, or that reported last time around.

So, what to make of it?  If you're in the equity/risk market camp you can celebrate, as this is another data point that pushes rate hikes out further into the future.  This keeps the Fed on the sidelines longer as they are clearly concerned about growth. 

We're approaching a critical time for both sides.  Yes, the market has been locked into a very narrow range for weeks now.  It seems we've been endlessly drifting around.  However, some clues are now there that may support higher prices.  We recently saw the Fed statement, sanguine about inflation and supportive of growing the economy.  They will leave 'well enough alone' for some time to come....any hint of rate hikes will be far off (late 2010) and gradual.  To be sure, the Fed will not want to ruffle any feathers.

As for the SPX, the 1100 number continues to be the magnet.  In fact, the 10 MA has been within 3 points of that number since Thanksgiving.  Now, that's what I call a tight range!  Reaching as high as 1119 and as low as 1085, the SPX has been bouncing along, taking trend traders down.  A rangebound market is good for premium sellers and stockpickers.  For the bulls to keep the momentum there has to be a move up soon.  This sticky 1100 level can be traced back to Oct 2008, where a major breakdown occurred.  So from a technical perspective...there is tugging on both sides of support and resistance.  Only time will resolve this, and it's just about time!

Ok, now the Fed may have some concerns.  The PPI came in much hotter than expected, and while they may want to see some price inflation this may be a worry.  Of course, one number does not a trend make, so we will have to another month or two to really start thinking about it.



There is a strong relationship between a strong dollar and higher rates.  Makes sense, really.  Good growth strengthens the currency yet with a low fed funds the yield curve expands, forcing short term rates to rise soon.  If the growth is inflationary rather than driven by productivity then the Fed must act to remove accomodation.

Lots to think about here, we'll see how the market responds.  If these bond auctions are not likely to go well there will be more pressure on rates.

Since last Friday's jobs number...much better than expected, the greenback has been on a roll.  The highest close in a month may mean the end of the dollar carry trade.  That unwind is going to take awhile and be tough on the dollar bears.  So why is this dollar rise getting so much attention?  You have to look at the bond market for the answers.  You see, strength in the economy is either organic or inflationary.  The Fed looks at this growth to determine the course of action with rates.   Conveniently, the bond market will help them forecast the growth.  A steep yield curve tells us growth is likely, perhaps too much.  Yields on the long end rise and raise the chances of short term rates pushing up (done by the Fed).  Well, the bond market sees something, and perhaps the jobs report confirms the stock market's meteoric rise, forecasting strong growth.

Certainly gold has been something to watch as well and got creamed this week.  the 1120 level is an area I would like to see stabilize before getting involved again.

Yesterday, the Fed delivered their statement from the second to last meeting of the year.  Basically, they kept everything status quo, not giving a hint as to when a rate rise will occur.  If you're a market watcher, you breathe a sigh of relief that the Fed is listening/watching things closely.  The economy is clearly not out of jail yet and they acknowledge it.  Regardless of your point of view about the Fed, they are supporting a HIGHER stock market now and into the end of the year...so it's time to get busy and start buying.  Gold is rising not because of inflation rather diversification away from the dollar.

I mentioned in this week's trendwatch that the markets were heading toward a breakout....and indeed it occurred this week.  I also said a range would be established, upside unknown so far.  The gap at 905 on SPX is begging to be filled, and could be on the next round of selling.  With only a week or so to go before the end of the month I can't see much of a selloff before then, especially given the recent strength and rotation.  The Fed is still accomodating, the credit market are improving and firms are beating low expectations...ingredients for a rally.  Energy names are upcoming, and should be good.

We get the Fed announcement on Wed, then later in the week Chairman Bernanke will testify about the whole BAC/MER mess that occurred last fall.  The first part is mostly dressing...we don't expect much from the Fed other than to say they could keep on buying treasury bonds, helping to keep rates low.  The testimony in front of Congress is going to be interesting.  What role did Bernanke play?  Was it illegal?  Will he implicate others?  President Obama is watching carefully, and if it doesn't pan out well we might have a new Fed Chairman next spring.   

Today we'll hear from a few Fed governors who step on the soapbox.  One in particular, Jeff Lacker, is a noted inflation hawk who has been squawking lately about his concerns.  Surely there is some inflation out there, look around you...just go to the gas pump and you'll see it.  But if he and the other governors display some concern over rising inflation, is it just lip service, smackdown/talkdown prices or are they really going to threaten higher rates?  The yield curve is quite steep now and portrays a picture of very healthy growth, perhaps too healthy.  The Fed actions tend to lag so even if they did raise rates the effect would not be felt until early 2010.  Keep your ears to the ground and pay attention to what is being said and by whom, that's the best edge you have in this game.

Many are beginning to speculate that the Fed may raise rates by the end of this year ... don't count on it, in my view its not likely.  Unemployment is still the #1 concern to both politicians and the public, and the jobless rate is rising not falling.  The Fed does not want to buck the new Presidential Administration, which keeps re-iterating that things will not turn around quickly and needs support for its various stimulus programs.