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July 15, 2005

Red flags are warning, Fri., July 15, 2005, 6:58 AM

There is a condition in capital markets today that I think is important for traders to be paying close attention to. I call it the interest rate syndrome.

As I recently illustrated by a chart of QQQQ (Nasdaq) vs. TLT (Lehman Bond Index), it has become apparent that equity investors in the U.S. have been linking higher interest rates to a belief that their economy is expanding quickly.

I think investors who are making such a presumption without further consideration of the negative impact of higher interest rates on a fragile real estate market (amid other concerns) are somewhat delusional.

At some point " which is called the tipping point " higher interest rates, which are presently knocking down bond prices, will begin to impact stock prices.

If you have been watching the bond market this past month you will see that rates are rising, but also that the yield spread is narrowing.

The latter, which is illustrated below, is a sign from the bond market that the economy is not healthy.

From the U.S. Fixed Income (Bonds) Yield Table at Yahoo Finance, the 30-year T-Bond (actually 26 years) is now yielding 4.41 pct, up from 4.21 pct just three weeks ago, which is a significant move. At the same time, the 3-month T-Bill yield moved up strongly, and relatively faster, from +2.82 to +3.06 pct.

Combine these two actions, and you see the spread between 30-year T-Bonds and 3-month T-Bills presently stands at +135 (which has dropped from almost +200 basis points two to three months ago). While the spread did collapse to +128 bp a couple weeks ago, and has improved slightly, this condition is still a red flag.

A yield spread of 300 basis points (between the 30-year and 3-month Treasuries) reflects a healthy economy in the U.S..

As the yield curve has been flattening over the past many months, traders have become aware of the fact that, rather than "it's the economy, stupid", it is in fact international money flows that are increasingly needed to keep the U.S. real estate and capital markets game afloat.

Should the real estate market and the bond market start to stumble here, it could dramatically affect the U.S. economy in a negative way, and quickly pull down the equity market.

Traders ought to be nervous, and come to their senses that the emotional reaction to the bombing of the mass transit system in London, and the North American auto price wars, which started in June, are not sustainable drivers of the equity markets.

Kudlow and Cramer and their friends at CNBC may be screaming at you that a new bull market has started, but I'm here to tell you, sadly, it's not true.

I wish it were true that the current bull cycle would continue through the 3Q05 and into 2006, but until the Chinese Yuan is revalued, the risk of holding dollar-sensitive and interest-rate sensitive instruments is excessive. There is greater risk to the downside than opportunity to the upside at this point.

The upcoming Yuan revaluation (and significant downward adjustment of the USD) is the reason I still like gold " and still think it will make a major move this year and perhaps next.

Many Americans are unnecessarily worried about the China government-controlled CNOOC acquiring strategic oil assets in a takeover of Unocal (NYSE: UCL). If China really was "the enemy", traders ought to be more concerned to what damage would be done to the U.S. economy should the authorities in Beijing decide to dump their USD reserves.

Even at that, the People's Bank of China will have to sell USD " hundreds of billions, which is not a good prospect. Rather they just use them to buy Unocal, and then maybe California.

Red flags are warning you to stop chasing stocks here (i.e., Dow 10,629).

So keep your eye on interest rates and currency moves this summer.

P.S. I'm looking forward to getting back to my Week in Review on Saturday.

Posted by Posted by Bill Cara on July 15, 2005 06:58:55 AM | Category: Bonds , Cara Today in the Market , China , Forex , U.S. Equities