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Forget the Headlines, Listen to the Bond Market!
By Clif Droke April 16, 2008
Let’s
turn our attention to something that isn’t often discussed, namely
bonds. I
know what some of you are saying already: “But bonds are
boring!” Yes, they
may well be boring in most instances.
But this isn’t one of those times.
Actually, the message of the bond market is one of the more
exciting and optimistic messages being sent anywhere in the
financial markets right now and it behooves us to pay close
attention to what bonds are saying.
The
collective message of the bond market is one that is being almost
entirely ignored by the financial press.
While millions of investors are caught up in the past,
cowering under their beds waiting for the next financial bomb to
drop, the bond market is screaming to all that will listen, “The
worst is over – the economy will improve!” To
show you what the bond market is saying, let’s look at some
revealing charts. To
start with, here is the chart of the LIBOR rate for the first three
months of 2008.
The
LIBOR, the London Interbank Offered Rate, is the most active
interest rate market in the world and is among the most common of
benchmark interest rate indexes used to make adjustments to
adjustable rate mortgages. As
such, it can be used to measure levels of fear among lenders related
to the subprime fiasco. The
LIBOR rate premium over the T-bill rate has been declining sharply
ever since peaking out back in mid-January.
When the Libor rate goes up sharply it reflects the intense
fear of British bankers over financial and economic conditions, just
as it did during the January panic.
But notice the Libor rate has been coming down conspicuously
ever since then and has not approached the high levels of fear of
over two months ago. The
public remains afraid, yet the monetary powers are clearly not as
worried over the state of Noted
economist Ed Yardeni noted back in February that, “ARM resets
are less threatening partly because of the Hope Now Next
we turn to the Treasury yield curve.
The Treasury yield curve is calculated by dividing the
10-year Treasury yield into the 3-month T-bill.
On a very basic level tells you gross profit margins of
financial institutions. They borrow short-term money and loan it out
at long-term yields. As
Don Hays recently pointed out, “For the last year, institutions
had no way to make money. They squeezed earnings by squeezing home
owners that could not afford the homes they were buying. Now, the
opportunity to make money is back with the 10-year Treasury [more
than] 50% higher than the 90-day T-bill. The Yield Curve also tells
you how much you are being rewarded to take risk. Six months ago,
there was no reason to take risk with short-term rates higher than
long-term rates. Now, the rewards are becoming greater to take more
risk by tying your money up longer.”
There
is some lag time between the improving yield curve and economic
performance, but probably by mid-summer you’ll be seeing some
noticeable improvements in the economy.
The beautiful performance of the yield curve guarantees that
improving liquidity will eventually translate into an improved
economic outlook.
The
improvement in the yield curve has been truly head-spinning and
incredible. In just a
1-week period in March, the yield curve rose from 2.57 to 9.78!
That’s the type of improvement you only see about once
every ten years. It
happens whenever the economy goes down too far and the monetary
authorities become panic-stricken about restoring liquidity to the
system. The
important 20-day moving average of the yield curve is what’s most
important to watch. As
long as it is giving a reading of 2.0 or higher it shows that the
financial system has abundant liquidity to work with and that the
economy is almost guaranteed to recover.
The online time the 20-day, or 4-week, moving average of the
Treasury yield curve went well above 2.0 was in 1992-1993 following
the early ‘90s recession (which led to major economic recovery).
It happened again in 2002 following the 2000-2001 recession
which led to major improvement in the consumer economy.
After
peaking in 2003, the yield curve moving average dropped and declined
all the way into 2007, which predicted a weak economy.
Now that the 4-week moving average of the yield curve has
risen to those healthy, bullish levels in reflection of monetary
growth again, it’s only a matter of time before we all see the
improvement in the economy, and by extension, the stock market. Here’s
another graph that most investors never look at.
It’s basically a daily comparison of the 2-year Treasury
yield minus the Fed Funds Target Rate.
Whenever this graph shows a rising trend, it indicates
improving monetary liquidity. Whenever
the graph goes above the “zero” line and into positive territory
it means that monetary liquidity has been turbo charged and the
results will be powerful. The
trend has been rising for some time and isn’t far from going into
positive territory.
Normally,
a falling 10-year Treasury yield would be interpreted as bullish for
the stock market. By
and large, that hasn’t been the case since the 10-year yield
started falling steadily last June.
This is because the intense fear of the last several months
have temporarily overpowered what used to be an inverse relation
between bond yields and the stock market.
The falling Treasury yield has instead been an indicator of
scared investors running to the perceived safety of the bond market. This
time when the yield on the 10-year Treasury starts rising again it
will actually be bullish for the economy.
Why? Because the
higher bond yields go above the Fed Funds Target Rate, the more
bullish will be the implication for monetary liquidity.
Below is a 10-month price oscillator I keep on the 10-year
Treasury Yield Index (TNX). While
it can’t be used to pinpoint turning points in the bond market, it
does provide a general idea that investors should expect a trend
reversal at some point in the not-too-distant future.
Notice how oversold TNX has become.
This suggests a reversal in the downtrend for Treasury yields
soon.
The
final consideration in the re-liquification process is the daily
securities lending volume. The
Fed has been loaning securities at a rate not seen in its history.
Take a look at the historic lending volumes of just the past
days – they are simply through the roof!
The
combined message of this action is that not only is the liquidity
crisis a thing of the past, but the widespread fears of further
economic deterioration are without foundation.
The bond market is saying, “Look forward, not backward.
Better times are coming!”
Clif Droke is the editor of the three times weekly Momentum Strategies Report newsletter, published since 1997, which covers U.S. equity markets and various stock sectors, natural resources, money supply and bank credit trends, the dollar and the U.S. economy. The forecasts are made using a unique proprietary blend of analytical methods involving internal momentum and moving average systems, as well as securities lending trends. He is also the author of numerous books, including "How to Read Chart Patterns for Greater Profits." For more information visit www.clifdroke.com
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