PREVIOUS INSTANCES OF FED TIGHTENING ACCOMPANIED RISING COMMODITY PRICES -- THE FED IS RAISING RATES NOW WHILE COMMODITIES ARE PLUNGING -- WEAK CHINESE MARKET IS PULLING COMMODITIES LOWER -- AND REFLECTS A SLOWING GLOBAL ECONOMY

LAST TWO YIELD CURVE INVERSION RESULTED FROM RISING COMMODITY PRICES ... My Wednesday morning message suggested that a sharp drop in the price of oil and other commodities argued for a more dovish tone from the Fed. That message also explained that previous Fed tightening cycles were usually done to combat rising inflation and higher commodity prices. Let's take a look at the two most recent times that happened. Chart 1 compares the CRB Commodity Index (brown bars) to the spread between ten and two year Treasury yields (green line) over the last twenty years. That period includes the two recent yield curve inversions that took place during 2000 and again in the period between 2006 and 2007. Both yield inversions are marked by red circles and occurred when the ten-year yield dropped below the two year (which pushed the spread below zero). The chart shows commodity prices rising in both instances. Both times the Fed raised short-term rates to slow the commodity price advance.

Chart 1

RISING COMMODITY PRICES LED TO 2000 YIELD INVERSION... The green line in Chart 2 shows the ten - two year yield spread falling below zero near the start of 2000 (when the ten year yield fell below the two year). The rising brown bars show commodity prices (including oil) rising sharply during the second half of 1999 which encouraged the Fed to raise short-term rates to slow the inflation threat. That led to the yield inversion near the start of 2000. In case you don't remember, the Nasdaq peaked in the spring of that year and the S&P 500 that October after which the economy entered a recession the following spring.

Chart 2

RISING COMMODITIES ALSO CONTRIBUTED TO 2006 INVERSION... Chart 3 shows the most recent yield curve inversion between the ten and two year Treasury yields taking place near the start of 2006 and lasting into the start of 2007. There again, rising commodity prices during 2005 and the first half of 2006 encouraged the Fed to raise short term rates enough to push the two year yield above the ten year and pushed their spread below zero (green circle). And that inversion helped set the stage for the stock market peak in October of 2007. That in turn preceded the start of the last recession that started two months later in December of that year. [For the record, commodity prices kept rising into the middle of 2008 before finally peaking. If you take another look at the brown bars in Chart 1, you'll see that commodity prices have been in decline since then. Which brings us to 2018.

Chart 3

COMMODITY PRICES ARE PLUNGING THIS TIME... Chart 4 compares the same ten - two year yield spread (green line) to the CRB Commodity Index (brown bars) over the last two years. Two things are different in Chart 4. First of all, the yield curve hasn't inverted yet. The ten year yield is currently 12 basis point over the two year. That's the lowest level in more than a decade (since 2007), but is still positive. The second thing that's different this time is that commodity prices are plunging (brown circle). This is the first time I can recall the Fed raising rates in the face of falling commodity prices in the fifty years that I've been charting the markets. Which kind of makes me wonder what the Fed is thinking. It kept rates historically low over the past decade in an attempt to lift the global economy out of a deflationary spiral by boosting inflation. More rate hikes could weaken commodity prices even more which threatens recent progress on achieving 2% inflation. A strong dollar resulting from more rate hikes would also weaken commodity prices in the coming year. At the same time, boosting short-term rates (while bond yields are falling) could itself cause the yield curve to invert which could threaten the U.S. economy. So could lower commodity prices resulting from reduced foreign demand. The Wall Street Journal points that two-thirds of foreign commodity demand comes from emerging Asia, and most of that from China.

Chart 4

WEAK CHINESE STOCKS ARE PULLING COMMODITY PRICES LOWER... Nothing happens in a vacuum. A lot of what's happening in the U.S. financial markets is being influenced by deteriorating conditions in foreign markets. Like China. The red bars in Chart 5 show the Shanghai Stock Composite Index in sharp decline this year. In fact, it has lost -28% from its January high which qualifies as a bear market. That reflects weakness in that country's economy which is the second biggest in the world. And that's bad for commodities. The brown bars in Chart 5 show commodity prices following Chinese stocks lower. That's because China is the world's biggest buyer of those commodities. It's also worth noting that the two weakest commodity groups this year have been energy and industrial metals. Both are considered bellwethers of the global economy. And right now they're sending a message of global weakness. The U.S. is part of that global economy. Shouldn't economists be factoring that into their rosy forecasts for next year?

Chart 5

U.S STOCKS ARE NOW IN A BEAR MARKET ... This week's drop by all major stock indexes below their early 2018 lows confirms that U.S. stocks have entered a bear market. Some parts of the market have already crossed the -20% threshold which also defines a bear market. They include small caps stocks and the transports, while the Nasdaq may be there by the end of the day. The energy sector has already lost dropped more than -20%, while several other sector SPDRs are dangerously closer to that bear market threshold which include consumer cyclicals, financials, industrials, materials, technology, and communications. Cash is usually the best place to hide in that weaker environment. What's unsettling is that the Fed (and most economists) don't seemed that concerned. They keep assuring us that the U.S. economy remains strong. But what about the negative impact from weaker foreign economies? If your best customers are losing their jobs, your company is in trouble. If foreign economies weaken, who's going to buy our exports?

ECONOMIC FUN: Economists are having fun with Paul Samuelson's 50-year old quip that "the stock market has predicted nine of the last five recessions". At least stocks got it right five times. That's probably five times more than most economists. Or the Fed.

TAKING A HOLIDAY BREAK ... This is my last message for the year. I'll be taking a little holiday break for the rest of the month. Here's wishing one and all a very Merry Christmas and a Happy New Year.