"This time it's different" is, at best, a well-trodden cliche enabling some self-serving interpretation of divergent behavior. At worst, it is the most dangerous phrase on Wall Street.
But sometimes change is real. Consider, in this case, the recent inversion of the Treasury yield curve, which seems to have generated very little hand-wringing over the potentially negative implications for economic growth.
An inversion of the yield curve, in which longer-dated-maturity Treasury bonds yield less than shorter-dated bonds, classically portend recession and overly tight monetary policy. This time around, as the market awaits the
Federal Open Market Committee's
meeting next week and an expected fed funds rate hike to 5.25%, the inverted yield curve underlies the Fed's shift of focus to inflation from growth.
It also reflects some good old-fashioned demand for U.S. fixed-income securities.
"At this late stage of the business cycle, a slight inversion is not atypical," says Jack Malvey, chief fixed income strategist at Lehman Brothers, who notes that in the last 60 years, parts of the yield curve have been inverted 52% of the time. After a day of very minor moves Monday, the inversion is currently between the two-year Treasury note with a 5.17% yield and the 10-year with a 5.14% yield. The 30-year bond's yield jumps back up to 5.18%.
After hinting harder at its concerns about a slowing housing market and a heavily pressured consumer, the Fed has altered its rhetoric in the past two months to focus squarely on inflation. As the long end of the yield curve usually tracks inflation expectations, the recent rally there means the bond market has become more comfortable with the prospects for long-term inflation as the Fed got more hawkish.
The yield curve inverted earlier this month on the heels of Fed Chairman Ben Bernanke's "tough talk" on inflation at a speech in Washington, D.C. This followed a barrage of Fedspeak in May when Fed presidents and governors harped on inflation running at the high end of the Fed's "comfort zone." Before the Fed let the hawks out of their cages, the yield curve was steeper. The 10-year peaked at 5.19% on May 12.
"The Treasury bond market is satisfied with the Fed's efforts to contain inflation," says John Lonski, chief economist at Moody's Investors Service.
The inflation focus is also visible in the value of the U.S. dollar, which rebounded when expectations increased for more rate hikes. The euro fell 0.44% vs. the dollar to $1.258 Monday, and the dollar strengthened 0.1% vs. the Japanese yen to 115.41. The Dollar Index, which measures the greenback vs. a basket of other currencies, is up 2.8% from its May lows.
The fed funds futures market has priced in 100% odds the Fed will raise the fed funds rate to 5.25% when it concludes its two-day FOMC meeting on June 29. The market has placed a 70% to 80% likelihood the fed funds rate goes to 5.5% by the end of the year. Several economists have upped their forecasts for the fed funds rate as well. Lehman's economic team Friday puts fed funds at 5.75% by October.
The Commodities Factor
Higher rates raise the risk of a hard landing for the economy, but fears about stagflation -- rising inflation plus slowing growth -- have dampened lately as commodities prices tumbled, a slide that
resumed Monday. The price of copper has fallen nearly 25% since its peak in May. Gold is down nearly 22% from its May high while silver has fallen 29%.
Commodities stocks such as
were certainly unpopular Monday, helping drag down blue-chip averages.
Dow Jones Industrial Average
fell 0.7% to 10,941.11, with
among its worst performers. The
ended down 0.91% at 1240.14. The
slipped 0.92% to 2110.42.
The S&P was further hampered by weakness in
, which tumbled 10% in heavy volume on news
struck a deal to combine their wireless network operations.
Falling commodities prices have reassured markets that inflation won't speed out of control. But whether or not commodities prices will rebound is hotly debated. Some say demand from developing nations like China will be enough to support a continued bull market in these assets. Others say the run-up in prices was largely speculative, and hedge funds took those bets off the table amid the global monetary policy-tightening that has taken shape this month.
World economic growth has to run at least 3% to keep commodity prices afloat, says Lonski. The IMF currently forecasts 2006 world economic growth at 4.9% for 2006, but with all the tightening of liquidity and rising rates across the globe, it is sure to slow.
Betting that commodities prices will remain in a bull market means betting that the world's central banks will not "overshoot" and stunt their economic growth too sharply, says Lonski. "That is a heroic assumption," albeit one that seemed to take hold among many traders amid Thursday's rally effort.
If commodity prices continue to fall, it is unlikely the yield curve will steepen until the Fed starts to cut rates, which many predict will happen in 2007. It would be hard to steepen the curve unless inflation and the economy regain momentum, says Lonski. Investors would then demand a greater inflation-risk premium. With housing data on tap for Tuesday, steeper is furthest from most traders' minds, especially after Monday's
lackluster report on homebuilders' sentiment, which put further downward pressure on the sector.
In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click
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