DROP IN BOND YIELDS HINT AT SLOWER ECONOMY -- FLATTENING YIELD CURVE IS HURTING BANKS -- SLOWER GROWTH LOWERS DOLLAR -- CRB INDEX HITS 25-YEAR HIGH

CRB INDEX SOARS ON HURRICANE ... Energy prices aren't the only ones being pushed higher by the recent hurricane. The CRB Index has climbed to the highest level in twenty-five years. Most of this week's gains have been seen in those commodities directly related to problems in the Gulf Coast region -- energy, coffee, cotton, sugar, and soybeans. The CRB is now trading near its all-time high reached in 1980 at the end of the inflationary spiral of the 1970's. It's amazing how many times things that are happening now in the various financial markets are resulting in references to that earlier decade. Within the last week, for example, I pointed out that the 2002 four-year cycle low in the stock market was lower than the previous low in October 1998. That's the first time that's happened since the 1970's as well. Money coming out of stocks is moving into bonds. That's pushing bond yields lower and may be hinting at economic slowing. The flattening yield curve is taking a negative toll on bank stocks which have been among the worst recent performers. Falling bond yields, and hints at economic slowing, are also weakening the dollar. That's also giving a boost to commodity prices.

Chart 1

BOUNCING EURO IS HELPING GOLD ... I recently wrote about the U.S. Dollar Index starting to roll over from its early 2004 peak near 90. Since the start of July, foreign currencies have been bouncing as the dollar has been dropping. Chart 2 shows the Euro bouncing off its 50-day moving average. That means the dollar is dropping. A bouncing Euro usually lends support to gold and gold shares. Chart 3 shows the Gold ETF (GLD) trying to hold at moving average support after gapping lower yesterday. The Gold & Silver (XAU) Index in Chart 4 is also trying to stabilize at its moving average lines. Gold stocks have been one of the market's strongest groups during the month of August as shown by the rising XAU:SPX ratio line. Part of the gold buying is tied to expectations for a weaker dollar which may be the result of lower U.S. bond yields and signs of slower economic growth in the U.S.

Chart 2

Chart 3

Chart 4

WHY BOND YIELDS ARE FALLING ... It may seem strange to see bond yields falling in the fact of rising commodity prices. In the past, the inflationary impact of rising prices would have produced higher bond yields. The best explanation I can come up with is that falling bond yields are hinting at economic weakness as a direct result of soaring energy costs. Falling bond yields have caused the yield curve to flatten to the lowest level in several years -- and it isn't that far from inverting. The last time that happened was at the start of 2000 and correctly signaled a weak stock market followed by an economic contraction. This time, however, the Fed seems less concerned about the threat from an inverted yield curve (when short-term rates move higher than long-term rates). In fact, their continual raising of short-term rates may even cause the yield curve to invert. That seems like a risky policy considering that the Fed has publicly expressed confusion at the lower level of bond yields. Two of the reasons bond yields are falling today is the lower revision in second quarter growth and a contraction in Chicago manufacturing for the first time since the spring of 2003. In other words, slower economic growth. That probably also explains why the dollar is dropping today. The flattening yield curve is hurting bank stocks.

Chart 5

BANKS ARE UNDERPERFORMING... It may seem strange to see a rate-sensitive group like bank stocks fall along with bond yields. The reason is that the main driver of bank stocks is the spread between short and long term rates. In other words, the yield curve. But first a look at how badly the bank stocks have been doing. The bars in Chart 6 show the PHLX Bank Index forming a potentially bearish head and shoulders topping pattern. To complete that bearish pattern, the BKX would have to break the neckline. It appears to be heading in that direction. Notice also that the BKX/SPX relative strength ratio has been falling since the summer of last year. That's underperformance. That's where the yield curve comes in.

Chart 6

THE YIELD CURVE DRIVES BANK PERFORMANCE ... The purple line in Chart 7 is the Bank Index/S&P 500 ratio shown in the preceding chart. The red line is the yield curve which compares the 10-year T-note yield to the three-month T-bill rate. The rising red line from the start of 2001 through the end of 2003 showed a widening yield curve. That was caused by the Fed lowering short-term rates aggressively to battle deflation and a falling stock market. That widening yield curve helped bank stocks outperform the rest of the market during those three years. The yield curve peaked, however, near the middle of 2004 as the Fed started to raise short-term rates. Since then rising short-term rates and falling long-term rates have caused the yield curve to flatten. That was right around the time that bank stocks started to underperform the market. The reason why the yield curve effects banks is that banks borrow short and lend long. They pay short-term rates on bank accounts and lend out at longer-term rates. When short-term rats are rising (as they are now), bank expenses rise. As long-term rates fall, however, bank returns on loans weaken. More than any factor, the direction of the yield curve drives the performance of bank stocks. Unfortunately, bank stocks (and financial stocks in general) are also considered to be leading indicators for the rest of the market.

Chart 7