03 Mar 2006 Back to Normal
After a month and a half since our office flood we are now back to normal. The wood floor is installed, carpets cleaned and laid, walls and baseboards replaced and painted, art hung on the walls, and furniture returned from various idle locations in our 30-story office building. ‘Normal,’ whether real or imagined is nice, even if for a short while. It’s what gives us a chance to catch our breath before the next round of challenge and growth.
Markets now seem to be in a stage of ‘rest’ as well. Stocks have mostly marched in place in the last few weeks following their energetic rise in January. Bombings inIraqandSaudi Arabiaor kidnappings inNigeriaseem to have diminishing influence on market movements. Regrettably they are becoming the norm, so markets have taken them in stride and held up remarkable well.
Speculation and debate continue over what Mr. Bernanke and his Fed think should be the norm for inflation and interest rates. Will he go further than he normally might in raising rates to prove his resolve in fighting inflation? Many believe he might increase more than the half percentage point markets now widely expect, but only if the economy continues to show it is able to bear the burden of more expensive capital.
Many also wonder and debate just how much the inverted yield curve means this time. Under normal circumstances in the past an inverted yield curve foretold of recession within a year or more. An inverted yield curve occurs when short-term interest rates are higher than long-term rates. Today’s US Treasury curve below shows that the 6-month, 2-year, and 5-year maturities all bear higher yields (4.75%, 4.758%, 4.7%) than the ten-year maturity at 4.69%.
Why is this important? Banks, the primary sources of capital in past economies, lend money to businesses at long-term rates while paying short-term rates to their customers through CD’s and savings accounts. They made money on the spread, the difference between short and long term rates. But when long term rates are below short-term rates, their profit margins get squeezed and they stop lending. This time is different, as argued by Mr. Bernanke and others in that there has been a huge influx of capital from other countries. As their economies thrive by producing goods sold toAmerica, they invest their profits in American assets like stable and guaranteed U.S. Treasuries. In essence, the world is financing our consumption and borrowing by buying longer term U.S. Treasuries. The bond market tells us that investors do not believe that inflation will erode their future bond earnings. Prices for long-term bonds have remained high as a result of unprecedented foreign demand.
The Federal Reserve is largely the reason that short term rates are higher than long. Under more ‘normal’ circumstances long term rates would have risen in sync with the Fed’s increases. That they haven’t has been a mystery to some and a powerful example to others as to how different this modern, technologically evolving global economy is from the past. Technology and ubiquitous information have facilitated manifold increases in the the avenues of capital to available to businesses. Local banks are no longer the only sources of capital. Hedge funds, private equity funds, foreign banks, and venture capitalists are flush with cash and ready to invest in exciting new opportunities, regardless of the relationship of short to long term yields.
The norm for stocks will likely be more of the same – backing and filling until Mr. Bernanke shows his hand. There are still plenty of investors who believe that the inverted yield curve is not obsolete as a predictor of economic slow-downs and they are keeping their cash on the sidelines. Businesses too are sitting on mountains of cash, more likely because they do not see compelling investment opportunities than of the predictive values of the yield curve. But until investing excitement returns, stock indices will likely continue to wallow about. Our challenge is to find and invest in those companies and countries that grow their revenues and earnings and attract investor praise, despite what goes on in the aimless markets.