SHORT-TERM RATES REMAIN BELOW LONG-TERM RATES -- BUT THE GAP IS NARROWING -- THAT'S BEEN GOOD FOR STOCKS IN THE PAST -- RISING SHORT-TERM RATES ARE HELPING THE DOLLAR -- BUT ARE BEARISH FOR GOLD -- FALLING BULLION IS WEIGHING ON GOLD MINERS
ANOTHER WAY TO LOOK AT YIELD CURVE... My Wednesday message included a paragraph on the yield curve. One of the charts, however, overlaid the 2-year and 10-year Treasury yields on the same chart. I was trying to show that short-term rates were rising, while long-term yields were dropping. That chart, however, may have been misleading, since it looked like short-term yields were actually higher than longer term ones. That's not the case. Chart 1 is a better way to compare to two yield maturities by putting them on the same scale. It compares the 10-Year T-Note yield (green line) to the two-year yield (red line) since 2007. It's clear that short-term rates have remained much lower than longer term yields throughout that period. That's symptomatic of an usually loose monetary policy. Chart 1 also shows that two-year yields have risen to .58% which is the highest level in three years. Meanwhile the 10-Year yield is at 2.54% which is well below its January high. The fact that short-term yields are rising, while longer-term yields are falling, causes the spread between the two (the yield curve) to narrow. That's the market's way of preparing for some Fed tightening. Bond yields are being held down by low inflation expectations and even lower foreign yields in Europe and Japan. Any move toward a tighter monetary policy by the Fed will be reflected in short-term rates before long-term rates. Short-term rates usually start rising well before the actual Fed announcement. [To create Chart 1, use "Price (same scale)" under the "Overlays" chart listing].
(click to view a live version of this chart)
Chart 1
RISING SHORT-TERM RATES CAN BE GOOD FOR STOCKS ... Chart 2 elaborates on yesterday's discussion of why a flattening yield has been good for stocks in the past. Most of the changes in the yield curve are caused by turns in short-term rates. When the market and the economy are weak, the Fed lowers short-term rates to try to stabilize things. Chart 2 shows the two-year yield plunging between 2000 and 2002 while the stock market fell. The same thing happened during 2007 and 2008. Falling short-term rates coincided with falling stock prices. Short-term rates turned up with stocks in 2003 and rose with them until 2006. That would seem to suggest that rising short-term rates are good for stocks. So why is everyone so concerned about the Fed's raising of short-term rates? Since 2009, the S&P 500 has surged to record highs, while the two-year yield has remained relatively low. That's because of the Fed's unusually loose monetary policy. The two-year yield would have to rise to 1.5% (triple where it is now) just to get back to where it was at the 2003 bottom. It would have to reach 5% to get back to where it was in 2006. There's no question that the Fed's keeping both short and long term rates at historically low levels has helped fuel the move into higher-yielding stocks. And that a rate hike might cause some nervous profit-taking in stocks. Given how low short-term rates are, however, Chart 2 suggests they would have to rise a lot to sidetrack the secular bull market in stocks.
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Chart 2
RISING SHORT-TERM YIELDS SUPPORT THE DOLLAR... I suggested yesterday that a stronger dollar was good for U.S. stocks. A stronger dollar is a vote for the American economy, relative to the rest of the world. It's also a bet on higher U.S. interest rates -- both on a absolute and relative basis. The red line in Chart 3 shows the two-year Treasury yield rising throughout 2014. The green line shows the U.S. Dollar Index doing the same. The rising red line shows "absolute" gains. "Relative" gains are even more impressive. While the two-year U.S. yield is trading at a three-year high (.58%), the German 2-yield is negative and dropping. The spread between short-term U.S. and German rates is the widest since 2007. That's supportive to the dollar.
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Chart 3
RISING RATES ARE BAD FOR GOLD ... I recently explained that a rising dollar is bearish for gold (and most commodities). So are rising rates (which often determine the direction of the dollar). Chart 4 shows a very strong inverse correlation between the price of gold and the 2-year Treasury yield. As a rule, falling rates are good for gold. That's because gold is non-yielding asset. As a result, it thrives when rates are low and falling. That was the case earlier in the last decade, and again after 2007. The plunge in short-term rates during 2007 helped the bull market in gold (that started in 2002) to continue. The bottom in the two-year yield in late 2011 coincided exactly with a peak in gold (see circles). The rise in short-term rates since then (see more clearly on a log scale) has corresponded with falling gold prices. Rising rates should continue to weigh on the precious metal.
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Chart 4
EVEN GOLD STOCKS ARE SLIPPING... Gold stocks have held up better than bullion. However, even they're starting to feel the negative impact of a rising dollar and falling gold prices. The daily bars in Chart 5 show the Market Vectors Gold Miners ETF (GDX) falling to the lowest level since June. Gold is doing even worse. The solid line shows the Gold Trust (GLD) dropping today to the lowest level in eight months. Falling gold prices should continue to weigh on gold miners.
