The nation's Democrats gather on the banks of the River Charles this week to offer their solutions to the world's problems. (Let me guess: Elect them?) They may wish to contemplate a remark I made to a friend in the summer of 2000: "The next guy in should keep a picture of Herbert Hoover on his desk."

Regardless of one's politics, the cruel and simple reality is that President Bush's economic policy had to react to the bursting bubble, and his foreign policy had to react to Sept. 11.

The next guy in should keep a picture of Alan Greenspan and then his successor handy. A real-time chart of the yield curve would not hurt, either.

Three of the top five industry groups in the S&P 500 in terms of total net operating income -- diversified financial services, banks and insurance -- are in the financial sector. That number would be even higher if General Electric ( GE) were classified as a financial firm instead of "miscellaneous manufacturing."

If we add the savings-and-loan group to this classification, only four financial groups account for 30.5% of the S&P's net operating income and 20.1% of its market capitalization.

Linked to the Curve

Much has been made, and rightfully so, of the financial sector's ability to dodge certain bullets so far. Fannie Mae ( FNM) and Freddie Mac ( FRE) have been able to ride out huge waves of refinancing and a couple of violent bond market selloffs in the past three years. Hopefully the occasional executive dismissals and accounting scandals bother only the squeamish. But, as noted here in September 2002 , the mortgage giants are nothing more than big bets on a continued steep yield curve at lower rates.

They are not alone. Just as cattle eat corn, then get turned into beef plus a few byproducts, financial firms process short-term savings into long-term investments plus a few byproducts. The lower the price of either corn or money, the greater the profitability of the processing operation. It really is that simple.

Weighting for Income
Source: Bloomberg

So even if, as I suggested last week , the Federal Reserve may be both loath and correct to raise short-term interest rates at much more than a measured pace, we may owe the absence of disaster in the financial sector more to the continued steepness of the yield curve than to adroit risk management. Translation: The banks, insurers, brokerages and hedge funds dotting the landscape, including a few in downtown Boston, may be more lucky than good. If and when the curve starts to flatten, the reckoning will begin.

The simple reality is that yield curves continue to remain steep, which continues to perpetuate the so-called carry trades of borrowing cheap short-term money to lend at longer-term horizons. The source of the funds borrowed is immaterial; the global financial asset boom of the late 1990s was financed largely by the cheap yen. The incentives for lending long are immaterial as well; much of the bond rally of January-February 2004 was financed by Asian central banks' frantic efforts to weaken their own currencies relative to the dollar.

Still Steep

We can measure the steepness of the yield curve by taking the ratio of a forward rate between any two maturities to the rate of the longer maturity itself. A forward rate between one and five years, for example, is the rate at which you can lock in borrowing for four years starting one year from now. The more this ratio exceeds 1.00, the steeper the yield curve is. An inverted yield curve has a forward rate ratio less than 1.00.

How much have various segments of the curve flattened since the FOMC warned about the dangers of deflation in May 2003? Overall, not very much. While the segments between two and five years and between five and 10 years started flattening considerably after the release of the March employment report in early April, that flattening has stopped. Paradoxically, the money market segment between six months and a year actually got steeper as one-year rates rose but the six-month rate stayed stable in anticipation of a kinder, gentler Fed.

Still Steep
Source: Bloomberg

Good News and Bad News

Over time, bank stocks have done a good job of anticipating changes in the yield curve; the one exception over the past decade occurred during the yen carry trade era of 1996-99. Banks got fat then by borrowing cheap yen, swapping them into dollars and doing who knows what therewith. The relative performance of the Philadelphia Bank Stock index to the S&P 500 led the steepening of the yield curve between the two-year and 10-year maturities following the bursting of the equity bubble in 2000. The same relative performance also led the flattening of the yield curve in 2003.

Getting Fat Off the Fed
Source: Bloomberg

Interestingly enough, while the yield curve has flattened over the past year, the relative performance of the bank stocks is still rich. Based on past relationships, one of these indicators is out of line: Either the yield curve will once again steepen as the Fed reacts to weakening economic conditions, or bank stocks will follow the flatter yield curve lower.

Either one of these convergence engines carries significant negatives; the former reflects a weaker economy and the latter reflects a sharp drop in the profitability of a major segment of the stock market. Neither development should be welcomed.

Barring a recession or worse, the carry trade will be over before any Kerry trades begin.
Howard L. Simons is a trading consultant and the author of The Dynamic Option Selection System. Under no circumstances does the information in this column represent a recommendation to buy or sell securities. While Simons cannot provide investment advice or recommendations, he invites you to send your feedback to howard.simons@thestreet.com.

TheStreet.com has a revenue-sharing relationship with Amazon.com under which it receives a portion of the revenue from Amazon purchases by customers directed there from TheStreet.com.

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