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Jeff Saut Presents: Curves

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Yield curves are typically asymptotically upward sloping since the longer the maturity, the higher the yield, meaning that yields rise as maturity lengthens...

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Editor's Note: The following article was written by Raymond James Chief Investment Strategist, Jeff Saut. It has been reproduced with permission for the benefit of the Minyanville community.


"Curves," except in this case I am not referring to the largest fitness franchise in the world, but the yield curve that has "firmed up" rather dramatically recently. As the astute folks at Bridgewater note:

"The biggest force behind the sell-off in bonds is a repricing of monetary policy expectations. Prior expectations of a significant economic slowdown are being contradicted by the data as well as the market action in equities, commodities and other markets. These conditions are being reinforced by fears that foreign central banks will be reducing U.S. bond purchases as one after another indicates a policy shift away from dollar bonds. The net result is that the yield curve is steepening led by rising long rates, while short rates and monetary policy are stable. The following chart shows the shift in the yield curve over the last month."


Click to enlarge


Ladies and gentlemen, Bridgewater's observations are not an unimportant point because the shape of the yield curve reflects investors' expectations about the economy's future growth, as well as inflation. Yield curves are typically asymptotically upward sloping since the longer the maturity, the higher the yield, meaning that yields rise as maturity lengthens (i.e., a positive sloped, or normal shaped, yield curve). This normally sloped curve suggests that higher inflationary pressures will cause the Federal Reserve to raise interest rates to dampen those pressures and slow economic growth. Since January I have opined that this might be the case, often commenting, "The fooler in 2007 could be that the economy reaccelerates and the Fed rather than lowering interest rates actually raises them." Yet, while the yield curve's shape has changed abruptly over the past few weeks, a few conundrums still exist.

Indeed, just last week Fed president Janet Yellen stated, "The sharp jump in interest rates in recent weeks hasn't gone far enough to resolve what former Fed chairman Alan Greenspan coined 'the bond rate conundrum'." Ms. Yellen went on to say, "Of course, long-term rates have risen in recent weeks, but not nearly enough to resolve Greenspan's conundrum." The Greenspan "conundrum" to which she refers is the behavior of long-term interest rates, which have not nearly kept pace with the 400% rise in short-term rates from June 2004 until June 2006. Consequently, while the yield curve has steepened, and in the process taken on a more normalized shape, it has not steepened enough... aka, "the conundrum."

Clearly, opinions vary on why this is the case. Some suggest it is because of petrodollar recycling. Others say it is due to the Chinese recycling of tradable-goods dollars. Still others think it is because the U.S. economy is set to slow in the back-half of this year, making long-term rates "sticky" on the upside. My sense is that it is likely a combination of all of these explanations and maybe others. Plainly, with crude oil prices where they are, OPEC is awash in dollars since the preponderance of oil transactions take place in U.S. dollars. It is just common-sensical, therefore, for those dollars to be recycled back into longer-dated U.S. debt instruments. Alarmingly, however, there is a growing movement toward investing some of those dollars in other non-dollar-denominated instruments due to the dollar's weakness.

As for China, I have long-stated that China will continue to favor the U.S. until no longer needed. To wit, China is getting importing technology from the U.S. that would have taken them years to develop on their own. China also has a vested interest in keeping the U.S. consumer alive and spending. Still, my sense is that once China has sucked the U.S. dry of its proprietary technologies, the recycling of its tradable-goods dollars will wane. And that brings me to the U.S. economic situation, which at the moment continues to look pretty good save the housing debacle and the strife in the automotive sector.

Verily, just last week the Fed's Beige Book reported that "economic activity continued to expand from mid- April through May." For example, May retail sales rebounded from a very weak April by rising a strong 1.4% versus expectations for a 0.6% rise, leaving them up 5.0% year-over-year. Likewise, business inventories rose a better than expected 0.4%, and while industrial production was flat in May, it was held back by a 1.3% decline in the U.S.' utility complex.

Yet by far the economic "star" of the week was the Empire State Manufacturing Index that leaped to 25.75 in June versus May's 8.03 reading. Troubling, however, was the "prices paid" component of this report since it showed that 42.6% of respondents were paying higher prices versus the prior month's 34.4% reading. These inflationary leanings were reflected in last week's headline CPI figures (+0.7% in May), which were the second highest in 16 years, that is still not being reflected in the laughable "core figures" (+0.1%), begging the question, "Can this particular 'conundrum' continue?!" Again, common sense says NO since the 25% increase in the Goldman Sachs Commodity Index over the past five months suggests that eventually commodity prices will bleed into the core readings.

This "agflation" has left grain prices at 10-year highs, stoking inflation fears in Europe and putting central bankers there on alert. Also adding to the agflation-agitations has been worldwide drought conditions, a fact that has not been lost on China, where foodstuff consumption accounts for a large portion of disposable income. Consequently, China has raised interest rates substantially over the last 12 months. Even Japan may have to join the international rate-rape since its 1Q '07 GDP was revised recently to +3.3%, from 2.6%, implying that growth there is stronger than both here and Europe. If Japan raises rates, it would have wide ranging implications for the ubiquitous "carry trade" that drove usage of currency and stock derivatives up 24% in the first quarter of this year to an astounding $533 trillion, but that is a discussion or another time.

Whatever the reason, in a little over one month the much discussed inverted yield curve has completely reversed in a classic "steepening move" that has confirmed a mega-trend reversal in long-term interest rates (read: higher rates). Worth noting is that the yield on the 10-year benchmark T'note has now traded above the Fed Funds rate for the first time in over a year. When that shift is combined with the fact that real GDP growth is also below the Fed Funds rate, history shows that economic growth has tended to slow. A similar sequence occurred in the first part of 2006 and stocks initially rallied in anticipation of a stronger economy only to decline once the economy weakened again, causing one savvy seer to lament, "Could this be déjà vu all over again?!"

Clearly, many conundrums exist; so far, however, the stock market is interpreting the events positively as if the fabled mid-cycle slowdown is behind us with economic growth set to revive. And with money supplies around the world surging, this may indeed be the case. However, higher interest rates typically create a need for higher equity risk premiums to compensate for the uncertainty about the future rate of inflation and the concurrent risk to the value of future cash flows. Additionally, P/E ratios tend to contract, not expand, as rates rise. In such an environment we have opted to play the "long side" of the equity markets in hopefully a safer way using larger capitalization names preferably with dividend yields. In past missives I have mentioned General Electric (GE), MeadWestvaco (MWV), Johnson & Johnson (JNJ), and Wachovia (WB), to name but a few, all of which are rated Buy or Outperform by Raymond James and/or one of our research correspondents. As a sidebar,4.6%-yielding Portugal Telecom (PT) owns a large portion of a Brazilian telecom company and was upgraded to Outperform by Credit Suisse last week.

In conclusion, last week a number of folks asked me for a more growthy idea. Subsequently, in my firm's verbal strategy comments we mentioned a stock that nearly every growth portfolio manager we know says is a must own stock, namely NII Holdings (formerly Nextel International). NII Holdings (NIHD), which has a Strong Buy rating from my firm's telecom analyst, provides digital wireless communication services to business customers located in select Latin American markets. The company's principal operations are in Mexico, Brazil, Argentina, and Peru. Given my firm's longstanding bullish views on all of these countries the opportunities for NIHD abound.

The call for this week: How "chickenly" appropriate that I will be on the road again this week, as the S&P 500 (SPX) approaches its reaction high around 1540 and with Alan Greenspan stating, "The global liquidity boom is near a turning point; enjoy it while you can!"

Nevertheless, it's worth noting the NASDAQ 100 (NDX) has held up better than the SPX and that Lowry's Buying Power Index finished last week at its highest level in more than 20 months.

Yet, with "the curves" suggesting growth may slow, and with productivity flagging, corporate profit margins, and therefore earnings, will likely come under pressure. And don't look now, but the Chinese became net sellers of U.S. Treasuries in April while the Reuters/CRB Continuous Commodity Index tagged a new all-time high, driven by weekly rises in wheat (+14.1%), corn (+10.2%), and gasoline (+8.1%) as the conundrums climb.

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