Fundamental Storm Brewing

          The Bond market (and most interest rates) reveal an inverted yield curve not seen since early this year which temporarily roiled the equity markets.  While many have ignored the phenomenon as just a temporary event of no economic or macro economic significance, we strongly disagree.  The yield curve has been one of the most reliable fundamental indicators over the past 100 years for the equity markets.  The reason is simple:  it is possible to manipulate small futures markets and interest rates via the Federal Reserve Board, fed funds or repurchase agreements, but it is very difficult to manipulate a trillion dollar debt market that trades internationally, not to mention the primary, secondary and debt tertiary markets.  So, if something is amiss, these markets are usually the most accurate in predicting economic expansion or recession.

           The debt markets are forecasting a recession.  The graphs above (courtesy of www.stockcharts.com) compares the present yield curve to the yield curve of September 2000 which signaled the stock market top.  To the left is a typical, slightly steep yield curve in normal conditions.  The yield curve is forecasting a near term recession and this is further supported by much of the economic data that has been released in recent weeks.  Add to that the over leveraged housing market and consumers at 126% debt to actual income and the phrase 'soft landing' are a euphemism coined by those that do not need to work for a living.  The answer to anemic job growth in the current expansion can be found by plucking the fruit of outsourcing, (labor arbitrage, etc ).

          Any new jobs that are created in the US are often performed overseas, thus, the US economy from a wage perspective will continue to grow slowly and the typical inflationary pressures usually seen have met the same fate as the dodo bird. Eventually the pendulum will swing the other way, or so the logic goes, but that is going to take more than a few quarters and quite  possibly decades. This is certainly a fundamental positive for debt instruments in the next few economic quarters.

          We find it interesting that the additional supply of bonds created by renewing the 30 year long bond issues has had little to no impact on prices or the yield curve.  It has, in fact, acted just the opposite of what one would expect with additional supply.  The US interest rate market is not the only market with such foreboding signs, and this type of agreement is particularly telling.  The Euro Bund and rates are also near the inflection point of inversion.  Again, history is very consistent here.  The 1998 Asian crisis and the 2000 stock market tops were the last time that euro rates also showed the looming danger of an inverted yield curve 

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