Tags: Greenspan | Has | Left | The | Building

Greenspan Has Left The Building

Saturday, 15 April 2006 12:00 AM

Dear MoneyNews Reader:

Those trying to make sense of the markets these days just got an extra wrench thrown into the works.

You will undoubtedly have read about the Greenspan Conundrum – the name bestowed on the curious development of long-term interest rates refusing to budge higher during a time of rising short-term rates. This strange development took place under the watch of then-Fed Chairman Alan Greenspan.

Well there's a new kid in town to take his place.

And now that there's an unofficial end in sight to the Fed raising short rates, long-term rates are at their highest in about two years. How come?

There was a time when rising bond rates would send skittish equity investors scurrying from stocks in fear that rising interest rates were bad for profits and would slow the economy.

Yet here we are, pushing at five-year highs in the main indices, just as bonds are yielding more. The story gets more intriguing all the while!

But once again, I'm going to put my money where my mouth is.

Several months ago in this column, I predicted that 10-year bond yields would trade in the 4.75-5% window. And this week I find 10-year U.S. government notes pinned up against the ceiling.


As I've mentioned lately, I'm starting to put my money where my mouth is with this trading service, pitting my market knowledge against market views.

As you can see from today's first chart, despite the rise in energy prices over the last couple of years, core inflation is remarkably calm at 2.1%.

The first hint of building price pressures would come from the producer price index (PPI). As you can see from the chart, it's not happening – not even with a time lag. In fact producer prices, which were recently running at 7% year-on-year, have actually turned back down.

I'm not saying that this will miraculously further deflate core inflation – just that core economic theory is perhaps changing in front of our very eyes.

Remember how I recently predicted that German bond yields would be on the rise? Well that was merely an observation that covered rising global bond yields.

With other national central banks caught in an earlier stage of the monetary tightening cycle, it currently feels as though inflationary pressures are taking center stage.

As you can see from the second chart (above), the Fed's "stair-stepping" policy of raising rates had little impact on the 10-year note yield, which has only just elevated to the highest level since rates began to rise.

This week, I came across a great explanation from Stephen Roach, chief global economist at Morgan Stanley.

He tried to explain how central banks could cause a new recession if they set domestic monetary conditions without considering the global inflationary profile – or perhaps I should say the lack of inflationary prospects.

Mr. Roach argues for what he calls "open macro" – as opposed to "closed macro" – policy-setting.

Thanks to the powerful forces of globalization (under which everything flows freely from trade, finance and labor to capital and labor), local policy needs to be carefully thought out, keeping one eye on the bigger picture.

He argues that globalization has unleashed a supply-side shock that has made many things cheaper and may cause a significant barrier to inflationary pressures.

In other words, globalization is also changing the way economic agents make decisions.

Mr. Roach cites evidence from the Bank for International Settlements (BIS), a Swiss banker that acts as a bank to the world's central banks, fostering cooperation between them all.

The BIS says that traditional relationships might have broken down. Labor costs no longer affect prices as they once did.

No longer do currencies impact import prices so greatly, nor do import prices affect core inflation. And the theory that output gaps affect core inflation has also become strained.

It's a phenomenon that has become marked during the last ten years, according to the BIS.

Researchers there have shown that when there is spare capacity or an output gap at a global level, it has more impact on a nation's inflation rate than does the nation's own output gap.

In other words, spare capacity across the globe has more effect on price levels in England or Argentina than do traditional local capacity constraints.

The lesson to be learned is that when countries exhaust their productive supplies, the rest of the world kicks in and prevents the build-up of price pressures in labor or capital markets.

With baited breath, we will be watching how the Federal Reserve responds to falling unemployment in the United States (now at 4.7%) and a factory capacity utilization rate of 80.4%. A decade ago, these very data series provoked additional tightening from the Fed.

Mr. Roach explains that the awakening of Japan and Germany, following years of slumber, cannot possibly mean that global demand is straining against capacity after years of underutilization.

Rather, the Chinese machine has spurred supply-driven growth through its export sector. Add in other Asian nations that have expanded in response to externally driven growth abroad, and you have evidence of plenty of slack in the broader economy.

I agree with Mr. Roach's observation that global price rules could mean that we won't see yields rise much higher than they have lately. That's why I'm a buyer of bonds at today's prices.

I bare the burden that I have misread the end to what Mr. Roach refers to as the "mother of all liquidity cycles." We may be at the very start of unwinding the Conundrum, now that all central banks are on the same side of the fence and raising interest rates.

However, global central banks could be creating the next deep recession should they continue to tighten simply out of fear that inflation is on the horizon – at a time when there is scant evidence it is really there.

If bond traders sense that happening, we'll be in for one hell of a bond rally in anticipation of remedial action.

According to Hedge Fund Research Inc., a Chicago-based research firm, first-quarter returns among the 1,700 hedge funds it monitors rose eightfold versus the same period a year ago.

Compared to the S&P 500 index, which returned a first-quarter gain of 3.73%, the various styles of hedge funds returned between 3.26% and 5.87%.

With such funds, good performance results in higher fees, since the funds take a hefty slice from investors – as much as 20% in many cases – on top of a standard 2% management fee.

London-based Man Group Plc exceeded its twelve-month profit forecast on account of a surge in assets under management. The company is the world's largest publicly traded hedge fund.


The surge in industrial and precious metals sent gold above $600 per ounce, while silver soared beyond $13. Both were multi-decade highs. Along with rising energy prices, hedge funds dedicated to these areas performed best.

An energy sector index provided by HedgeFund.net showed a quarterly gain of 8.56%.

The worst performers this month were currency and fixed-income funds.

The lack of clear direction for the dollar makes it more difficult to ride a trend, while bonds bet the wrong way on the yield curve throughout the quarter.

Many funds wagered on a widening of the spread between short and long rates – so they lost money when the curve continued to invert, causing long rates to rise more slowly than shorter-term rates.

The United States Oil Fund LP (Ticker: USO) reflects the price of West Texas intermediary (WTI). The fund's launch comes at a time when crude oil is trading at its highest price since after Hurricane Katrina in August 2005.


At the same time, for the fifth week in a row, crude oil inventories rose. Inventories of gasoline and other distillates continued to decline, proving that refineries can't keep up with demand for fuel.

In that sense, OPEC is doing its job, while domestic refineries still seemed to be bumped up against the constraints of idle capacity thanks to hurricane-related damage.

There's still no word on the launch of the silver ETF, which I alerted you to here on March 11.

At the time, silver was trading at less than $10 per ounce. And thanks to, among other things, euphoria surrounding the possibility of this ETF's imminent launch, silver has taken off like a bullet, trading at $13.01 last week.

In the leveraged world of commodities trading, each dollar rise in the price of an ounce of silver is worth $5,000.

Have a great week!

Andrew Wilkinson


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Dear MoneyNews Reader: Those trying to make sense of the markets these days just got an extra wrench thrown into the works. You will undoubtedly have read about the Greenspan Conundrum - the name bestowed on the curious development of long-term interest rates refusing to...
Saturday, 15 April 2006 12:00 AM
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