FIRST QUARTILE ECONOMICS |
Capital Markets Review, June 8, 1998
INTERNATIONAL EQUITIES: The S+P 500 rose by 2.1 percent on the week fueled by a solid gain of 1.7 percent on Friday, in the wake of a firm bond market. In Asia, problems persist as the Japanese Nikkei 225 fell 2.2 percent while Hong Kong’s Hang Seng Index fell a solid 4.1 percent.
The Hang Seng is now down 15 percent over the past month and is at critical channel support going back to 1992. At these levels, the Hong Kong market is a technical buy but the fundamentals say otherwise. Lots of recent talk that Hong Kong is now in recession is something they are not used to over there. Indeed the whole Asian region, by varying degrees, is just entering the recession that financial markets were discounting late last year. To the extent this is valid, the U.S. economy has barely felt any of the slowing impact that will result over the next year or so.
COMMODITY PRICES: Gold prices fell by $1.30/oz last week as concern about Swiss central bank selling emerged and the prospects of continued excellent global inflation fundamentals removed some of gold’s recent inflation hedge premium. There has now been plenty of technical damage to the recent rebound in gold prices and we should not be surprised to see a re-test of the low $277.50 level posted in early-1998.
As recently anticipated here, the CRB Index has convincingly broken down and is probably headed another 5 to 7 percent lower, to the 1992-cycle low. This remains great news for North American fixed income markets as the window of favorable inflation performance is actually getting wider rather than closing. Early this past week, the Purchasing Managers’ Prices Paid Index for May was reported at levels that are typically seen in the midst of deep recession, and whatever may be happening on the wage inflation front is more than being offset on the input prices front.
U.S. BONDS: Anyone forecasting the current shape of the U.S. yield curve several months ago would no doubt have suffered a fair degree of second guessing among clients and peers. Amidst a generally perceived backdrop of the next Fed move being that of a tightening, yields are acting in an unconventional manner. The 2 to 10-year part of the curve is essentially flat at just several basis points above the 5.50 percent Fed Funds rate. The 30-year Treasury is some 20 basis points higher in yield and offers the only value in terms of term extension.
The bond market has had plenty of chances to break down in the past few months but the momentum now favors new lows on the 30-year Treasury. The latest Non-farm payroll employment report was actually not very favorable for fixed income markets, with an employment gain of 296,000 yet long bonds rose over 1/2 point at the end of the week. If this is the type of response notionally bearish data will get over the near term, bullish data will likely have a disproportionately positive impact on bond prices.
The market may be worried about the Fed but it is also gradually coming to terms with the reality and sustainability of current inflation levels. For a long time now, the market has taken the 2 percent inflation zone with a heavy dose of skepticism as if 3 percent was just always around the corner if the Fed did not act in time. More and more, there seems to be a sense that inflation will not re-emerge rapidly and to the extent that traditional signs of rising inflation do begin to show up, the Fed will act accordingly.
This logic means the next Fed tightening cycle will be bullish for long rates because it virtually guarantees a longer term consolidation of inflation below 2 percent. In this scheme of things, long term real interest rates of some 4 percent are still pretty attractive regardless of the general flatness of the yield curve. Secondly, to the extent the degree of any Fed tightening cycle is usually proportional to the intensity of underlying inflation pressures, the next Fed tightening cycle should be rather mild. In fact, who is to say the Fed is not currently still in a tightening cycle. After all, the Fed raised the Fed Funds rate in March 1997 and maybe the odd Fed tightening every several months is what lies ahead over the next couple of years. One thing seems for sure: most of the post-war economic and financial market cycle history is now virtually obsolete and traditional ways of trying to explain and interpret economic and financial market developments are significantly less reliable than in the past as well.
Does this make me a proponent of the “cycle is dead” school of thought? Absolutely not! Rather, I believe that low inflation creates a different economic cycle, one in which low inflation breeds low inflation and necessarily lower interest rates. Based on this approach, we cannot say where we are in the domestic or global economic cycle. I do, however, think the North American cycle has at least two years of decent economic growth ahead before anything approximating the traditional end of the cycle generally manifests itself, i.e. genuinely rising inflation pressures.
U.S. DOLLAR: The dollar is in a superb position to rally further against the Yen but the proximity to the 140 level brings on a realistic threat of Bank of Japan intervention. Just as the 135 level held up as a technical obstacle for several months partly as a result of BoJ intervention, the 140 area could prove somewhat formidable. The bottom line is that the Yen remains fundamentally overvalued and short term rallies for whatever reasons should be viewed as temporary.
The USD/DM relationship is currently fairly neutral. Strong economic data out of Germany have reinforced the view that Germany faces higher interest rates reasonably soon. As a counterbalance, the strong U.S. economy is viewed as facing higher interest rates at some stage as well. Accordingly, there is no broad trend underway between the dollar and DM. The best indicator of potential DM weakness is the DM/Yen cross rate which puts the DM at major channel resistance versus the Yen. It would therefore appear that continued dollar strength versus the Yen should now translate into immediate strength versus the DM. Overall, the USD is a general positive for U.S. financial markets.
CANADIAN BONDS: Domestic short rates are making little or no allowance for a possible Bank of Canada interest rate increase any time soon. The long end does seem positioned for higher short rates as the negative spreads to the U.S. have narrowed by some 5 to 10 basis points over the past month. Other things being equal, the next Bank Rate hike will put domestic 3-month Treasury Bill yields some 5 to 10 basis points below their U.S. counterparts or essentially even yield. At even money market yields, the scope for ongoing weakness of the Canadian dollar is significantly diminished.
Against this background, the Canadian market will move largely in tandem with the U.S. over the next several months. Curve flattening will occur from a combination of either higher domestic money market rates or lower U.S. long rates. In either scenario Canadian long bonds will prevail in terms of return performance.
CANADIAN DOLLAR: The currency gave up more ground to the USD during the past week and a test of new lows is a virtual certainty over the next several weeks. CAD closed the week at 1.4580 versus 1.4565 last week and produced a weekly trading range of 1.4490 to 1.4605. There is virtually nothing in place to stop a move towards 1.4700 in the period ahead. Technically, as suggested by the chart below, CAD has room to sell-off to the 1.4750 area before channel support sets in.
Presently, the gradual erosion of the currency has produced little drama on the interest rate anticipation front especially since the market thinks the Bank of Canada is reluctant to raise interest rates. It remains likely that the Bank is prepared to act at some stage and we may be closer than the market implicitly believes. The next chart on the Monetary Conditions Index indicates that there has been the monetary equivalent of a 100 basis point decline in interest rates during the past couple of months. Even though the Bank has recently stated its comfort with the recent level of monetary conditions, it is doubtful that comfort level is the same now as a few weeks ago.
The MCI chart implies an upturn in the MCI very soon either in the form of a stronger CAD, stronger USD generally, or higher domestic money market rates. It is likely the CAD will soon take on a more volatile tone and as domestic money market participants do not seem positioned for an imminent Bank Rate increase, such a move will likely have greater currency calming effects than usual. Fundamentally, Canada does not particularly need higher interest rates just yet but this ultimately limits the scope for higher interest rates down the road, e.g., positive for long bonds.
June 8, 1998
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