Don't Fight the Inverted Yield Curve

By: Gary Dorsch | Tue, Mar 28, 2006
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The Federal Reserve is widely expected to lift the federal funds rate by a quarter point for the 15th time since June 2004, or 375 basis points higher to 4.75%, yet the yield on the US Treasury's 10-year Note is roughly unchanged at 4.65%, where it stood 21 months ago. With the upcoming rate hike to 4.75%, the US Treasury yield curve could flip back into inversion, where longer term yields are higher slightly than short term rates.

The newly anointed Fed chief Ben Bernanke, carries a reputation in the precious metals market as a radical inflationist, and is anxious to shed some of his dovish feathers with a March 28th rate hike, despite the probable outcome of a slightly inverted yield curve. However, while a dove may gather the courage to hike the fed funds rate when the yield curve is flat, only a hawkish central banker would dare to invert the yield curve by 50 basis points or more, with the most recent notable examples of the Bank of Brazil and the Reserve Bank of New Zealand.

Other central banks such as the Reserve Bank of Australia and the Bank of England fell into a state of frozen paralysis, once their yield curves became slightly inverted, and stood motionless as their currencies collapsed against the value of gold and silver. For now, the betting on Wall Street is that Bernanke would not convert from a super-dove to a hawk anytime soon, but would be content with the status of a wise old owl, and halt the Fed's rate hike campaign at 4.75% or no more than 5 percent.

On March 21st, Fed chief Bernanke said low long-term bond yields aren't signaling an economic slowdown. "I would not interpret the currently very flat yield curve as indicating a significant economic slowdown." Instead, Bernanke attributes low long-term rates to the Fed's inflation-fighting credibility and to a surge in investment in the US bonds from foreign central banks and Arab oil kingdoms.

If short and long-term rates are narrowing because investors are willing at accept less risk due to stable inflation, he said, "the implications for future economic activity are positive rather than negative. With long-term inflation expectations apparently anchored at low levels and with the prospect of continued economic stability, market participants may believe that it is appropriate to price bonds for an environment like that which prevailed four or five decades ago," Bernanke said.

However, with gold, silver and the Reuters Commodity (CRB) Index trading at or near 25-year highs, and itching to go higher, very few astute investors would agree with Bernanke's propaganda about low inflation. Gold and silver traders place more faith in the hard dollars and cents flowing through the commodities markets, than inflation statistics that are fashioned by government apparatchniks.

So Bernanke presented a second and more plausible explanation, citing the $2.7 trillion of US dollar reserves held by Asian central banks, and the recycling of petrodollars by Arab oil kingdoms in the Persian Gulf. But "reserve accumulation abroad is not the only, or even the dominant explanation for the recent behavior of low long-term Treasury yields" he said. Foreign holdings of US Treasury and agency debt held at the Fed rose by $198 billion to $1.587 trillion over the past 52-weeks. The supply of long-term bonds "seems not to have kept pace with demand."

Low long-term interest rates complicate the Fed's job of managing the economy because they negate the effects of higher short-term rates. Today's 4.66% yield on the 10-year note is little changed from June 2004, when the Fed began the longest series of rate increases in more than 25-years. "If spending depends on long-term interest rates, and special factors lower those rates, then overall demand will be stimulated and a higher short-term rate is required," Bernanke said.

However, sales of new US homes had the biggest monthly decline in almost nine years in February and the number of properties on the market rose, evidence the housing bubble is deflating after a five-year boom. Sales fell 10.5% to an annual rate of 1.08 million, the lowest since May 2003, from a revised 1.207 million in January. The number of homes for sale rose to a record 548,000 from January's 525,000.

At the current sales pace, there were enough new homes on the market to satisfy demand for the next 6.3 months, the largest amount in more than a decade. The median selling price of a new home last month was $230,400, from $243,900 in October. A gauge of US mortgage applications fell last week to the lowest level of the year as home purchases and refinancing declined.

A rapidly deflating housing bubble is one of the biggest risks facing the US economy because it would drag down consumer wealth and spending and threaten high-paid jobs in the real estate industry. Housing wealth surged by $5 trillion in the first half of the decade, and is the most powerful generator of consumer wealth since nearly 70% of American households own homes.

US households extracted $600 billion from their home equity in 2005 to spend and invest, according to the FDIC, far eclipsing their $375 billion gain in after-tax income. Falling home prices could wreck havoc on household finances, and put many speculators on shaky financial ground because they took out huge mortgages with adjustable-rate mortgages keyed to rates driven higher by the Fed.

But the Federal Reserve has no intention of preserving all of the recent gains in home price values, said Fed governor Donald Kohn on March 17th. "If real estate prices begin to erode, homeowners should not expect to see all the gains of recent years preserved by monetary policy actions," Kohn warned in a speech delivered to a European Central Bank forum in Frankfurt, Germany.

In his remarks, Kohn attacked the popular "Greenspan put" theory that Fed policy would always protect investors from sharp asset market drops while doing nothing to restrain these markets when prices rise. "This argument strikes me as a misreading of history. Conventional policy as practiced by the Federal Reserve has not insulated investors from downside risk," he said.

"Whatever might have once been thought about the existence of a 'Greenspan put,' stock market, investors could not have endured the experience of the last five years in the United States and concluded that they were hedged on the downside by asymmetric monetary policy," Kohn said.

"The same considerations apply to homeowners. All else being equal, interest rates are higher now than they would be were real estate valuations less lofty, and if real estate prices begin to erode, homeowners should not expect to see all the gains of recent years preserved by monetary policy actions," Kohn said.

However, the true test of the Fed's anti-inflation resolve would become more apparent if it can maintain a 4.75% or 5.00% fed funds rate in the face of declining US home prices. Already, the US dollar is showing technical signs of topping out, as traders anticipate an end to the rate hike campaign. However, if the Fed follows the example of the Bank of England, which panicked in August 2005, and lowered its base rate by a quarter-point to prevent a downturn in UK home prices, the US dollar could plunge, and gold and silver prices could climb higher.

The Bank of England has kept its benchmark interest rate on hold for seven months at 4.50%, because UK home prices have stabilized, according to HBOS, the country's biggest mortgage lender. Deputy BOE governor, John Gieve, noted on January 26th, "over the last 18 months we've seen a fair degree of stability in house prices." The only region that saw a drop in prices was North England, where values fell 0.1% in January, according to Hometrack.

However, on an annual basis, home prices across the UK fell 1.6% in 2005. Approvals for British home loans fell to their lowest in 12-months in January, totaling 45,039 last month, and weaker than December's 51,233. BOE chief economist Charlie Bean said high debt levels meant that small interest rate rises had a bigger impact on consumers' borrowing and spending patterns.

With an inverted yield curve holding intact from August 2004, the BOE sought an insurance policy against an economic recession by lowering its base rate to 4.50% in August 2005. Since then, merger mania and soaring natural resource shares have pushed the UK's Footsie-100 index above the 6000-level, and HBOS projects a 3% rise in UK home prices this year. However, the doves at the BOE may wait to restore the base rate to 4.75%, until the inverted yield curve disappears.

The BOE's Bean said on August 27th, 2004 the British central bank would not try to combat higher oil prices with a tighter monetary policy, and has been true to its word. "The MPC would only consider rising oil prices a serious issue if prices reached between $80 and $90 a barrel. It is more like an irritant," he said, referring to the inflationary impact of current oil prices.

And while the Footsie-100's gain of 13.7% since August 2005 looks good on paper, in hard money terms, its has lost 27% to the price of gold, which jumped to as high as 330 British pounds per ounce from 245 pounds/oz. Once it became apparent the BOE would ease its monetary policy to support home prices, and as a consequence weaken the British pound, the price of gold climbed sharply higher in London.

On January 16th 2006, with gold crossing 300 British pounds per ounce, the Bank of England chief Mervyn King acknowledged that a wide range of asset classes had risen, including stocks, real estate, commodities, gold and precious metals. "Monetary policy will, therefore, need to be alert to the information contained in a wide range of asset prices, to be forward-looking in its aim of maintaining low and stable inflation, and be ready to respond to changes in the signposts," he warned.

"At some point the ratio of asset prices to the prices of goods and services will revert to more normal levels," King said, adding there are two ways that could come about. "Either the prices of goods and services rise to catch up with asset prices as the increased money supply leads to higher inflation, or asset prices fall back as markets reassess the appropriate levels of risk premium. Our central view remains one of steady growth and low inflation," he predicted.

Since then, the BOE has given no indication that it is about to tackle soaring gold and commodity prices, and instead, sits in fear of the inverted UK yield curve. When asked about the possibility of raising rates in March 2006, the BOE's King answered, "The honest answer to this is, I don't know. What we do know are the issues that will determine the interest rates. In our case, it is inflation. The worst thing that you can do in economic policy is to pretend that you know."

The Reserve Bank of Australia kept its benchmark rate at 5.50% for a 12th month, and RBA chief Ian Macfarlane said on February 17th, "We have no present intention to change rates. History tells us that normally at this stage of an expansion it's far more likely that upward pressure on inflation will prevail and you will need to react to it. That's all we're saying." Australia's economy is in a record 15th year of expansion, and gained 2.6% in the third quarter from a year earlier.

"There is a risk that current labor market tightness will result in higher-than-expected wage increases. This will be an important area to watch in the months ahead," McFarlane said. Australia's wage price index, which measures hourly pay rates, rose 4.2% in the third quarter from a year earlier, the biggest gain since the series started in 1997. Australia's mining sector is still running hot, with operating profits in the fourth quarter up 57% from a year earlier.

Despite the tough talk about fighting inflation, the RBA's monetary policy has been paralyzed in fear of an inverted Australian yield curve. Yet since August 2005, the price of gold has risen by 42% to 798 Australian dollars per ounce, and the Aussie dollar tumbled by 5% to 70.50 US-cents last week to an 18-month low. The Australian stock market crossed the psychological 5000-mark, celebrating the Aussie dollar's devaluation, but the RBA appears reluctant to tighten rates to combat inflation, until the yield curve moves out of negative territory.

While the RBA and BOE monetary policies have been left unchanged in fear of the inverted yield curve, the Reserve Bank of New Zealand, dared to go where few central banks have gone before, to combat a 16% housing inflation rate in December. The RBNZ hiked it cash rate on five occasions after the yield curve had already inverted to 7.25%, and in the process, inverted the New Zealand yield curve by as much as 165 basis points.

After hiking its overnight loan rate to 7.25%, the RBNZ warned on December 9th, "With immigration having fallen dramatically, and with increasing signs that house prices are overvalued relative to incomes, we are expecting a sharp decline in house price inflation in the coming years, that it was likely to significantly slow household consumption." The central bank projected consumption growth to slow to zero in 2006 from around 5% last year. "The main downside risk of our projection is the prospect of a faster-than-expected correction in domestic demand, leading to a harder landing for the economy and a more rapid easing of inflation pressures."

RBNZ chief Alan Bollard said on March 8 th, that he is unlikely to cut the benchmark interest rate from a record 7.25% in 2006, because a slowing economy has yet to reduce inflation risks. Bollard said inflation will remain near the top of his target rate of between 1% and 3% for at least another year. "Inflationary risks mean we won't be likely to cut rates this calendar year," Bollard said after leaving rates unchanged. "We don't have a recessionary picture."

However, on March 24th, Wellington said New Zealand's economy contracted in the fourth quarter, triggering a sharp drop in the NZ kiwi and heightening expectations that the central bank would cut interest rates later this year. Once dubbed a high-flying economy, New Zealand said its gross domestic product fell 0.1% in the fourth quarter, the first decline in 5-½ years, following a downwardly revised 0.1% gain in the third quarter. NZ's economy expanded by just 2.2% in 2005, its slowest pace since 2001 and is a marked slowdown from 4.3% in 2004.

It is doubtful that the RBNZ would be able to hold its cash rate at 7.25% for the remainder of this year as the NZ economy continues to lose momentum. The RNNZ has not cut its cash rate since the middle of 2003. Finance officials point the finger of blame for the weaker economy to the overvalued NZ kiwi, which had been a favorite haven for yield-starved Japanese investors. The strong kiwi dealt a big blow to NZ exports and tourism, which account for 40% of NZ's $97 billion economy.

Japanese retail investors looking for high yields abroad bought a record $12 billion worth of the New Zealand dollar uridashi bonds in 2005. However, the New Zealand kiwi peaked at a post-float 23-year high of 74.65 US-cents in March 2005, and is now in a free-fall situation, amid expectations of a deteriorating economy and the end to the central bank's tightening cycle

Finance minister Michael Cullen was jawboning the kiwi lower on March 24th, the kiwi become "unstuck from the unrealistic heights. There certainly appear to be sufficient downwards pressures to maintain that trend." He said an easing in global commodity prices and the prospect of overseas central banks raising their interest rates as New Zealand rates appeared to have peaked were part of the reason for the kiwi's decline. "Cumulatively, these factors indicate that the road for the New Zealand dollar is pointed south," Cullen said.

Japanese retail demand helped maintain the strength of the kiwi at a time when it should have been falling. The whopping size of New Zealand's current account deficit, the gap between what the country spends and what it earns, widened to a record NZ$13.7 billion in the fourth quarter to 8.9% of gross domestic product from 8.5% in the 12 months ended September 30th.

Trade Minister Phil Goff said on March 16th, the kiwi's decline after a long rally would make New Zealand exports more competitive overseas, and help reduce the country's current account deficit. "The forecasts suggest the kiwi will settle somewhere between 59 and 65 US-cents. "I think that most New Zealand companies would find that to be a reasonable level to operate from," he said.

"We have a strong economy but we have a large current account deficit and the fall in the New Zealand dollar is going to be good for exporters, and it will bring our current account back into balance. From a level that was perhaps unsustainably high, we believe it will come back to a more comfortable level, but still a level above where it was five years ago," Goff said.

So far, the RBNZ's predictions about a slowdown in consumer spending and a weaker housing market in 2006 are starting to materialize. A government report on March 14th showed retail sales stalled in January. The median house price fell 1.7% to NZ$295,000 from the record high reached in January, or 9.6% above the same month a year earlier, and the lowest since April 2003. Existing home sales in February were 7,930 units, or 22% lower than a year earlier

RBNZ Governor Alan Bollard on March 9th forecast the current account gap would widen to 9% of GDP by March 31st, and 9.25% a year later. The average price paid for crude oil imports in the fourth quarter was NZ$656 a ton, or 22% more than the year-earlier quarter, putting pressure on the deficit. To escape injury from a weak kiwi, foreign investors reduced their holdings of New Zealand's debt in February to 64% of the total from a near-record 67% in January.

Standard & Poor's said in January the widening current account deficit, and the probability it will get wider, was a risk to New Zealand's AA+ sovereign credit rating. And unlike the central banks of Asia, the RBNZ has a scant $5.3 billion of foreign currency reserves on hand to combat a speculative rout of its currency. With the NZ kiwi in a free-fall, local investors have turned to assets that can benefit from the currency devaluation, such as gold and blue chip stocks.

Gold rose above its September 1986 high of $NZ910 per ounce last week, and is up about 55% from a year ago. The RBNZ is caught in a terrible bind, with soaring gold prices and currency devaluation on one hand, and a slumping housing market on the other. An easier RBNZ monetary policy could create a negative backlash among foreign investors, and send long term bond yields higher.

Annual inflation eased to 3.2% in the fourth quarter from five-year highs of 3.4% in the previous quarter, but remained above the RBNZ's 1 to 3% target range. "Continuing increases in wages, energy prices and other business costs suggest that inflation pressures will not subside quickly," Bollard said on January 26th. "Of particular concern, inflation expectations remain uncomfortably high."

So with business sentiment plunging to 20 year lows in the fourth quarter, and consumer confidence at a five-year low, NZ Prime minister Helen Clark welcomed the devaluation of the NZ kiwi on March 16th. "I think we should see what's happening in the currency, which is still strong, as positive for exporting. The extent to which the currency has come off the peak to the level of around 64 US-cents at the present time will be seen as a tremendous impetus to exporting," she said.

For the US-based investor however, the 11.5% rise in the NZ-50 stock index over the past five weeks, was completely wiped out by the devaluation of the NZ kiwi against the US dollar. For local NZ investors, familiar will past devaluations of the kiwi, gold still looks like a better buy than local stocks.

While it might seem absurd to compare the US economy to the smaller UK, Australia, and New Zealand economies, all four are generating record current account deficits, have flat or falling housing markets after bubble like performances, and also have inverted yield curves. So will Mr Bernanke choose to fight the inverted yield curve, following the example of RBNZ, by jacking-up the fed funds rate to 5% or higher to combat inflation expectations in the precious metals markets, but also risking a weaker housing market?

Or will the Bernanke Fed follow the path of the RBA and BOE, and stop hiking rates at 4.75%, leaving a slightly inverted yield curve, that doesn't risk a recession, such as the one that is about to sweep New Zealand? But if the Fed stops its rate hike campaign at 4.75%, while the Bank of Japan and the European Central Bank are tightening their monetary policies, how would the Bernanke Fed react to a falling US dollar, which could energize the precious metals and the "Commodity Super Cycle"?

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Gary Dorsch

Author: Gary Dorsch

Gary Dorsch

Gary Dorsch

Mr Dorsch worked on the trading floor of the Chicago Mercantile Exchange for nine years as the chief Financial Futures Analyst for three clearing firms, Oppenheimer Rouse Futures Inc, GH Miller and Company, and a commodity fund at the LNS Financial Group.

As a transactional broker for Charles Schwab's Global Investment Services department, Mr Dorsch handled thousands of customer trades in 45 stock exchanges around the world, including Australia, Canada, Japan, Hong Kong, the Euro zone, London, Toronto, South Africa, Mexico, and New Zealand, and Canadian oil trusts, ADR's and Exchange Traded Funds.

He wrote a weekly newsletter from 2000 thru September 2005 called, "Foreign Currency Trends" for Charles Schwab's Global Investment department, featuring inter-market technical analysis, to understand the dynamic inter-relationships between the foreign exchange, global bond and stock markets, and key industrial commodities.

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