The liquidity-driven markets of March 2003 through March 2004 reflected comfort with several odd combinations. These included strong acceleration in global growth along with deflation worries, at least from the Federal Reserve. Another odd couple was physical commodity prices' strongest rally in decades, accompanied by a continued decline in bond yields.
Yet as we saw briefly at the end of January, while investor behavior was in a familiar rut, attitudes were not. The mere changing of the Federal Open Market Committee's statement of risk assessments, highlighted by the use of "patient" instead of "considerable," triggered a short-lived run for the exits.
These attitudes reflected an awareness that the various surreal combinations of strange bedfellows would have to unwind at some point, and that previous behaviors had resulted in the accumulation of risk in too many leveraged positions. The sudden abruption of the longstanding uptrend in real estate investment trusts, following the April 2 employment report, was an especially spectacular reaction to prospects for deleveraging, but it probably will not be the last one we see in 2004.
|No Bids Found For REITs |
Commodities and the China TradeBoth commodity prices and emerging markets have been beneficiaries of the liquidity trade. Because activity in both sectors involves ocean freight, it is probably a good time to revisit an old favorite around these parts, the Baltic Dry Freight index, last viewed here in detail in
The BDIY is a composite index subsuming several smaller indices, each representing different vessel classes. Smaller ocean freighters (those between 35,000 and 50,000 deadweight tons) moving a variety of goods are tracked by the Handymax index. The next step up, vessels of less than 70,000 deadweight tons and capable of moving grain and coal through the Panama Canal, are tracked by the Panamax index. Finally, the larger vessels used for ores fall into the Capesize index.
|Freight Rates Turn Lower |
While all of these indices have retraced a significant portion of their late 2003 rally, the largest retracement has been in the Capesize index, the one most reflecting demand for industrial commodities like iron ore and copper. Given the need for ore exporters to nominate vessels for their exports ahead of time, we should expect to see the Capesize index lead the price of an economically sensitive commodity such as copper. This is exactly what's happening.
|One Ore In The Water |
The downturn in Capesize rates led the late 2003 rally in copper by 30 days, and since its peak on Jan. 19, 2004, it has led the top in three-month copper forwards on the London Metals Exchange. This is not a recessionary development, but merely one reflecting a slowdown in the rate of demand for copper and other industrial commodities.
Impact on Financial MarketsAt one point, it would have been quite simple to look at the drop in indicators such as freight rates or copper prices and conclude that interest rates would be falling apace, or at least not rising.
But given the experiences of the past year, where expanding exports from Asia to the U.S. coincided with massive central bank purchases of bonds by those countries to support the dollar, we need to be careful about making any sort of knee-jerk conclusions. The relationship between 10-year note yields and the BDIY, predictably positive prior to April 2002, has been strongly inverse since then.
|Rally Together, Stall Together |
The transmission for this inverse relationship has been the movements of the dollar and the aforementioned efforts of the Bank of Japan and others to support it by buying vast quantities of U.S. debt. The dollar began its strong decline at the April 2002 point noted above. Interestingly enough, the Handymax index has led the end of the bear market in the dollar by 33 days, roughly the nomination lead time for smaller vessels.
|Boats And Notes |
The dollar's decline was precipitated by the Federal Reserve's aggressive rate-cutting campaign. For whatever criticisms we can level at the Fed, we cannot quibble at its success in forestalling deflation and in setting the stage for the strong commodities and freight markets that followed.
However, the prospects for higher short-term interest rates in the U.S. may lead to a stronger dollar and an end to the interventions. As suggested here in
Unlike the FOMC's semantic virtuosos, freight rates give clear and unambiguous warnings. A further decline in the indices should lead to lower commodity prices; this signal is being confirmed by the lackluster performance of the
While this may be welcome in many quarters, if it is accompanied by prospects for higher short-term rates, we could be in for a massive deleveraging of fixed income investments that would make last week's REIT selloff look like a day at the beach.