| "What's good is bad, what's bad is good. You'll find out when you reach the top, you're on the bottom." |
| -- Bob Dylan |
WENTY-SIX YEARS AGO,
WHEN BOB DYLAN penned the song Idiot Wind, he was presumably railing
against the mean-spirited hypocrisy of his critics. Supposedly music is
timeless, which explains why lines like the ones quoted above and throughout the
following comments still apply -- but now to economic sages rather than art
critics.
After all, how else can you explain the Chairman of the Federal Reserve portraying productivity increases as bad for the economy, a sounder federal budget roiling the bond market, and stock investors "rotating" to utilities in the face of rising interest rates? It seems like the idiot wind is just a hair under gale force.
Of course there is some sense to be made of this -- but not much. Anyway, here's an attempt.
"They Won the War After Losing Every Battle"
Most of the volatility in the stock and bond markets can still be traced to concern over the direction of interest rates. Chairman Greenspan and several other Federal Reserve governors continue to imply that rates will have to rise further in order to head off the threat of inflation. As long as these threats persist, the markets won't trade on fundamentals.Yet even Mr. Greenspan had to admit to Congress in his February Humphrey-Hawkins testimony, there's still no real indication that inflation has started to accelerate. Despite all the fretting about rising oil prices and a soaring stock market, the Fed seems to be winning the inflation war without taking either of those battles.
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 Source: Baseline |
Actually, those battles aren't even worth fighting. Rising oil prices serve as a tax on consumers, effectively slowing the economy. In the short-term, they work to the Fed's advantage.
A rising stock market is also nothing to fear. Presumably, the connection comes from consumer confidence that rises with stock performance and a growing economy. As consumers feel more complacent, they're more willing to spend, driving the economy closer to inflationary excesses.
But this seemingly logical argument doesn't support the facts. In the words of a Ed Keon, quant analyst for Prudential Securities,
No reading of the historical data could possibly support the notion that a strong stock market causes inflation. Similarly, many commentators seem to accept the notion that strong economic growth must inevitably cause higher inflation... The only time in post-WWII U.S. economic history that high growth appeared to lead to inflation was in the later 1960's. But it seems to us that this was clearly due to President Johnson's desire to expand the Vietnam War without raising taxes to pay for it. As a result, the U.S. had highly stimulative fiscal policy at a time of genuine capacity constraints. But today we have high surpluses and restrictive fiscal policy, combined with high real interest rates.
So it's no wonder the Fed is winning the inflation war while losing the stock market/growth battles -- the two aren't related. More precisely, the relationship runs the other way: The stock market is soaring and the economy continues to grow because inflation is low. They don't cause inflation, they benefit from low inflation.
"Everything's a Little Upside Down"
Bond investors aren't so sanguine. (By nature they're worriers, otherwise they'd be buying stocks instead of bonds.) After suffering a terrible year in 1999, you can forgive them for being a little shell-shocked. Recently, the bond market has rivaled the stock market when it comes to volatility.The most remarkable development has been the so-called "inversion" of the yield curve. This phenomenon, while not unheard of, is certainly the exception to the rule.
The Treasury yield curve is a simple graphical representation of the current yields of various maturities. It typically slopes upward with yields rising with maturities. This configuration makes sense for two reasons.
First, shorter-term bonds are usually less sensitive to moves in interest rates since they have a relatively short time to maturity. But longer-term bonds assume a longer commitment and have a much greater opportunity to harm the buy-and-hold investor if interest rates move unfavorably. As a result, longer-term bonds must offer higher yields in order to entice investors to accept their added risk.
Secondly, the yield curve can be viewed as investors' prediction of future inflation. Even if inflation runs at today's low rate, it will compound and have a significant effect on the value of longer-term bonds. As a result, investors will demand higher yields at the longer end of the curve just to break even with inflation.
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 Source: Baseline |
In general, the steeper the slope of the curve, the greater the predicted level of inflation. But when the curve inverts, as it did in February, longer yields are actually lower than shorter ones.
In the past, this configuration tended to indicate the onset of a recession. It occurred when the Fed (which controls the short end of the curve) was aggressively tightening in an effort to fight off inflation. At the same time, inflation (which is reflected at the long end of the curve) is usually perceived as cresting, posing a lesser threat in the future. The Fed often overshoots at the short end, raising rates too aggressively, stifling growth, and sending the economy into a recession. While this validates the long end's inflation prediction, it's an awfully steep price to pay.
But this scenario doesn't really hold this time. Although the Fed is raising rates, it has been slow and systematic, not nearly as aggressive as in the past. Perhaps this is because the Fed is being proactive and not simply reactive as in the past.
Also, rather than believing inflation has peaked, most think it's just starting to heat up. Given that, you certainly wouldn't think the 30-year Treasury bond would yield less than the 5-year note.
Unlike before, however, the Treasury is about to begin buying back bonds. Initially Treasury Secretary Summers indicated these repurchases would be at the long end of the yield curve. (That would make sense for at the very least, it would allow longer, higher-yielding debt to be replaced at a lower cost.) While this had been rumored for quite some time, his announcement caught the bond market off guard, quickly driving up the price of the long bond and sending its yield (which moves inversely with price) down from over 6.40% to 6.07%.
This explanation has nothing to do with Fed rate increases or predictions of inflation. Instead, it's purely supply and demand driven. If the Treasury buys bonds, fewer will remain on the market thus reducing supply and driving up prices. Since Mr. Summers initially implied purchases would only be made at the long end, only those yields went down, inverting the curve.
While this is a nice neat explanation of the yield curve's current configuration, there are two things to consider. First, in the true spirit of the idiot wind, after roiling the bond market, Mr. Summers subsequently modified his announcement and indicated the Treasury's repurchases may be made across all maturities, not just those at the long end. This should have eased the inversion, but it didn't. Could something else be at work here?
Which leads us to the second point: Perhaps supply and demand aren't the real reasons for the current configuration. Maybe, as in the past, it is signaling an impending recession. If the Fed keeps raising rates -- no matter how slowly -- they'll eventually choke off growth, making recession an ever increasing possibility.
"Haunted by Your Memory and All Your Raging Glory"
This can also be the result if the Fed continues tightening to quell the stock market. Ever since his "irrational exuberance" comments back in 1996, Mr. Greenspan often warns of the dangers of the frothy bull market. In his Humphrey-Hawkins testimony in February, he indicated the Fed would continue to raise rates until the stock market begins to cool.Unfortunately, this approach has worked in reverse. Rather than stop the market's raging glory, each rate increase has only served to make its rise more concentrated and steep. This, too, is a change from the past.
Before when the Fed tightened credit, higher rates and less liquidity crimped earnings and brought the markets down. But this time, it hasn't
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Source: Lehman Brothers Large caps led all other capitalizations in the past several years at least partially because of the strong technology presence in the S&P 500. But now the other indexes have increased their weightings in technology, too. As a result, small and mid cap indexes have performed better as most of their returns have come from technology. |
As a result, the market has stratified into two tiers: technology stocks reaching new highs, and everything else, experiencing a bear market. As the nearby chart shows, the "market" as reported by popular indexes continues to advance, but only because technology has become so much of the market.
Previous episodes like this have ended poorly. Although you'd hope the lagging sectors would catch back up the the leaders, it's usually the other way around. This will again be the result if the Fed continues down the path of tighter credit.
"I Waited for You While Springtime Turned Slowly Into Autumn"
Of course the Fed isn't caught in the idiot wind swirling down Wall Street or around Washington. The Fed governors are much more knowledgeable than market analysts, politicians, or even economic commentators. So far their bark has been a lot worse than their bite and despite tighter credit, the market and the economy have continued to push forward.|
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 Source: Baseline |
Perhaps all the fear and trepidation hanging over the financial markets will be sufficient to slow them without further, aggressive Fed moves. If so, one more rate increase may enough to satisfy the Fed. If this is the case, the markets will stabilize by late spring or early summer, and be poised to resume a concerted upward move by the autumn. The date of the final Fed action and tone of their statements will determine the exact timing.
Until then, however, volatility will dominate both stocks and bonds. Markets hate uncertainty and that's exactly what they've had to deal with for the past year. Until the cloud of uncertainty lifts, look for narrow markets with sharp, often daily, swings.
In the short-term, it's a stock picker's market, but there are excellent opportunities developing for the long-term investor. For growth investors, large pharmaceutical companies are near 52-week lows. This includes the likes of Merck, Johnson & Johnson, and Eli Lilly. For value investors, the financial sector (with the exception of the brokerage firms) is rife with bargains. Also, quality cap goods (e.g. Honeywell and Solectron) are offering a buying opportunity.
The key for investors is to not be distracted by the short-term bumps. Unless the Fed really does overreact and send the economy into recession, the second half of the year will look a lot better. Of course this is an election year, so the idiot wind can easily blow into November.
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