The treacherous US bond and stock market interactions over the past three days (June 6-8) almost make one forget that barely a week or so before, at least the public equity market seemed to believe in a renewed “Goldilocks” scenario — everything was turning out “just right”.
The US economy was recovering nicely from the first quarter 2007 “bottoming” of GDP growth at .6%; inflation as most recently measured was coming off the boil and down closer to the Fed’s preferred range; the dollar was steadying in world markets; oil prices were at least in a relatively stable range betwen $62 and $66 per barrel; business investment was picking up after a slow start early in the year; solid job growth was continuing to underpin consumer sentiment and spending despite high gas prices and the persisting housing market downturn; and the Dow Industrials were setting record after record in a quickening march to “infinity and beyond”, or at least 14,000!
None of that (excpet the Dow) had changed at mid-week. But quicker than you can say “Ben Bernanke” (or maybe “Bill Gross”), the ten-year note caught a serious cold and all of a sudden the stock market’s focus shifted from Goldilocks to the “Three Bears” — (1) interest rates; (2) credit liquidity; and (3) the possible end to the ongoing M&A boom triggered by low (1) and plenty of (2).
The new trading hypothesis seemed to be:
(i) since the Goldilocks scenario in effect ruled out a Fed rate decrease in the forseeable future, maybe we need to start forseeing a possible Fed rate increase (look what the European Central Bank just did — although in truth that well-telegraphed move should have been no surprise to the market);
(ii) and as the bond market anticipates that Fed rate increase, we will quickly see yields on the ten-year benchmark shooting up to 5.25% and beyond — a direction-changing “higher-high” in the language of the chartists — that might well signal the onset of
(iii) a credit crunch in the high yield and other money-pots feeding the leveraged buyout/share buyback phenomena central to the M&A boom (May 2007 witnessed the third-highest deal volume on record), which together have removed enough equity from the public market to keep a solid “floor” under stock market valuations.
But, at the end of the day, has Goldilocks really morphed overnight into her ursine archenemies? Or is there something more prosaic going on? I suggest the following:
(A) The bond market is simply and grudgingly coming to the conclusion that the Fed and its new Chairman have been right all along about the economy’s resiliency, and that the bond market itself has been wrong to trade at levels suggesting that the Fed ought to have been lowering the benchmark interest rate.
(B) Given a recovering but surely not overheating economy, it is past time for an adjustment to a more “normalized” (ie, not inverted) yield curve with long rates at least equal to short — and a return to “normal” at 5.25% for ten-year paper, after all, is not a portent of a credit crunch in any fair reading of recorded economic history.
(C) The stock market meanwhile is shedding, in a healthy way, the element of complacency that was emerging in the daily record closes and preparing for a round of reassessments that will indeed get back to separating winners from losers, but not take down the whole shebang.
Notably, if the Three Bears scenario were to take hold, it could be a self-fulfilling (and brutally self-correcting) prophecy. An interest-rate-induced credit crunch would surely trigger the debacle in the housing market that we have successfully avoided to this point: namely, a substantial downturn in the traditional (ie, non-”sub-prime”) mortgage market that could indeed wreck the economy (and of course bring down interest rates violently).
Net-net, then, the markets seem to have recoverd their perspective by week’s end, but have probably assumed a new “on the lookout” posture for the famous Three Bears — exactly what any smart Goldilocks would do when walking through the forest, especially in the summer, when the bears come out to eat.
Filed under: Uncategorized
Recent Comments