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Wilkinson's Edge: The Edge of the Curve

Friday, 30 December 2005 12:00 AM

Dear MoneyNews Reader,

It seems like ages ago that I boldly predicted in my

But that's exactly what happened this week - and the event has been a driving theme for the U.S. stock market.

First, let's revisit the definition of "inversion."

What we are looking at here is the difference between the yield on two benchmark government notes. We are measuring the spread between the two-year and 10-year notes. Under normal circumstances the 10-year is higher than the two-year.

But when the 10-year yield falls below the two-year, the curve is said to have "inverted." This phenomenon is important because traders are effectively predicting a recession in the near future because of it.

So now that it's here, what does it mean, what caused it and are traders really convinced that it is an accurate indicator of recession?

That's the thing.

There does not seem to be a consensus opinion one way or another. At best, I hear more analysts challenging the popular view than agreeing with it. But then again, the market is the best-known arbiter of price.

That's the bad news.

However, I'm having a hard time finding many people who can fan the flames of recessionary evidence.

The recent rise in interest rates, along with the Fed's softened stance in its accompanying statement, has prompted investors to discount both an end to the tightening cycle and the potential for rates to start actually falling in the future.

As much as I respect market pricing, once again I find myself raising the contrarian flag.

I think that it would be foolhardy to fully buy into the ongoing notion that the U.S. is plunging headlong into recession - and from that perspective, I'm wary of the apparent message.

To begin, you have to set the background.

The Greenspan Conundrum has played a huge role in what we are seeing happen today. The fact that longer-dated yields have failed to behave conventionally during the 18-month tightening cycle should have made this week's curve inversion a high-probability event.

But outgoing Fed Chairman Alan Greenspan has already announced that he's tossing out the rule book on this one.

In other words, we should not interpret the treasury curve's unusual behavior to mean that inflation is not a threat. At the same time, it does not signal that a recession is necessarily on the cards.

So basically, the textbook on dealing with yield-curve inversion needs rewriting.

Here's the key question: What evidence is there that the economy is stalling?

Traders and investors had feared that high energy costs would do two things - restrain the economy and

So it's a logical fear that the Fed would address inflationary threats by strangling the economy.

However, because the end of monetary tightening is in sight and energy fears haven't played out to their maximum, I am led to believe that investors have arrived at a premature conclusion.

One reason may well be that there is too much money sloshing around in the system.

Take a look at the following chart showing the annual change in the money supply as measured by M3.

With the turnaround in monetary growth fueling the economy and basically greasing the wheels of commerce, financial institutions and foreign governments need to invest their hoards of cash somewhere.

So what could be safer than government bonds?

For the year through to October, foreign governments and investors had increased their purchases of U.S. government debt by 10% to stand at $2.1 trillion.

Is it possible that in a relatively low inflationary environment, investors are simply looking for yield at any cost?

This is especially conceivable when you consider that the entire 10% increase in treasury holdings seems to have come from corporations that refuse to invest in their own businesses, opting instead to buy government debt.

Bill Gross is a legendary bond manager at Pimco, the world's largest fixed-income investor. He suggests that in recent years there has been a gradual erosion of what should be considered "normal" interest rates.

He believes that the Asian and OPEC producing nations have run protective trade strategies, resulting in an accumulation of wealth for those countries. That surplus of wealth is being continually recycled into U.S. treasury debt.

The exertion of that overwhelming force has reduced nominal interest rates by perhaps 2% - and it is unlikely to go away anytime soon.

This week another healthy consumer confidence report proved once again that the economy is far from being up against the ropes.

An inverted yield curve makes it more difficult for financial lenders to make money. Banks work by borrowing short and lending long. That difference equates to a bank's profit.

So not only does a flat or negative curve mean less profit - it can actually create losses for lenders. And that's a negative for the financial sector, especially at a time when apparently we should be predicting a recession.

But last time I looked at financial companies on my charts, they weren't showing signs of falling into a bear market - not with the economy roaring ahead at a 4.1% pace.

I also want to draw upon an excellent observation made in daily commentary from currency expert Jack Crooks at Black Swan Capital Management.

He points out that the pessimism displayed by the surge toward inversion doesn't necessarily sit well with evidence from the global commodity markets.

As Jack mentions, the copper market is once again hitting fresh highs based on fundamentally strong demand - especially within China.

Jack illustrates the strong relationship between the U.S. housing market (of course, copper is a huge input in construction) and the price of copper futures.

Their link is uncanny, and the recent declines in the housing market are possibly making fixed-income investors believe that the new-homes market is stalling.

If that's true, then surely a recession is coming.

But hold on!

What if the slowdown turns out to be a gentle one, or it provokes the Fed to simply pause its tightening policy?

That's a little different than either a plunging real estate market or a turnaround in the prospects for monetary policy.

Meanwhile, copper imports in China peaked in August at 410,000 tons, which is a 57% increase over the same time the previous year. And Chinese construction and copper demand continue their firm upward trend.

In November, the Chinese government forecast that consumption might rise 8.6% to 3.8 million tons. That would leave a deficit of 1.1 million tons, compared to Chinese output, leaving imports to plug the gap.

Global supply is extremely tight. As a result, copper workers are announcing lightning work strikes - since they know they have the upper hand over management in terms of pay as copper prices reach for the stratosphere.

For instance, Chile's Codelco, the world's largest copper producer, is being held for ransom by its own workers at a time when global supplies are running on just four days' production. At the same time, industrial production in Japan is expanding.

Hardly sounds like a global downturn, does it?

But what about gold?

It is more precious than industrial (although it is used in the computer-manufacturing process), but what is its price telling us about investors' fear of a slowdown?

As you know,

The explanation for gold's rally may be found in the Pimco argument. The flood of global liquidity has the potential to create inflation. On the flipside, the constant recycling of dollars into treasuries will keep yields low.

Whichever path you choose will make a good background for gold prospects. You see, gold loves inflation or deflation since it's perceived as a store of value under any conditions.

Now reconsider Jack Crooks' conclusion regarding the inversion of the yield curve. He makes a valid point.

The specter of the inverting curve will be enough to put investors on recession watch.

Crooks also points out that the recent European Central Bank rate rise - which had been heralded as a one-off adjustment - may soon be followed by more.

Rising consumer confidence will surely bring forth more.

At the same time, the perception among investors is that there is an end in sight to rising U.S. rates and that it will alter what have been driving forces behind the exchange equilibrium between the dollar and the euro.

Mr. Crooks' observation fits right in with my own in that the dollar's rally may have run its course.

He recently recommended buying euros and selling dollars.

Let's see if we are both right.

Have a great 2006! 

Andrew Wilkinson


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Dear MoneyNews Reader, It seems like ages ago that I boldly predicted in my But that's exactly what happened this week - and the event has been a driving theme for the U.S. stock market. First, let's revisit the definition of "inversion." What we are looking at...
Friday, 30 December 2005 12:00 AM
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