The US Bond Market and the A$

In the Jan-03 Interim Update we stated our belief that the 30-Year T-Bond had peaked (long-term interest rates had bottomed) and that T-Bond yields would move quickly up to the 5.75-6.00% range. The following chart comparison of the Australian Dollar and the T-Bond Yield supports that view.

The chart is quite extraordinary in that it shows a strong positive correlation between two seemingly-unrelated items - US interest rates and the A$. Note that every significant turn in the US bond market over the past 15 years has either occurred in parallel with a turn in the A$ or has lagged a turn in the A$ by up to 3 months. This relationship suggested that the upward reversal in the A$ during the final 2 months of last year would soon be followed by an upward reversal in US interest rates.

The positive correlation between the A$ and the T-Bond Yield probably arises because the A$ tends to benefit from both a weaker US Dollar and stronger commodity prices, whereas bonds tend to be weak (bond yields tend to rise) during periods of USD weakness and/or commodity price strength.

In addition to corroborating our existing negative view (as of Jan-03) on the US bond market, the A$-bond relationship has other potential uses. Firstly, a move in either market can be used to confirm a move in the other market. For example, the A$ is currently retracing some of its recent gains, a normal occurrence after a strong up-move. However, if the A$ breaks to new lows we will know that Jan-03 represented only a short-term peak in the bond market, rather than a peak of longer-term significance. Similarly, a move to new highs by the bond market (a move to new lows by bond yields) would point towards a decline to new lows by the A$. Secondly, if the moves in the A$ and the bond market confirm each other we can confidently use this information to ascertain trends in other markets. For example, if the A$ strengthens over the next several months, as the A$-bond relationship currently suggests it will, then we are going to see US Dollar weakness and/or commodity price strength over this period.

Further to the above and assuming the bond market continues to confirm, the A$ is likely to be one of the world's strongest currencies over the next 12 months. There are certainly some fundamental reasons not to be bullish on the A$, including a huge current account deficit, the fact that Australia's net foreign debt rose by 23.5% over the past 12 months (versus GDP growth of 4.7%), and evidence that the Australian economy is slowing at a rapid pace. However, these problems may have already been discounted by last year's plunge to around US$0.50.

Stocks

Stocks versus Liquidity

Below is an updated version of a chart that originally appeared in the Dec-04 Weekly Market Update. The chart compares the 13-week rate-of-change (ROC) of the NASDAQ Composite Index with the 13-week ROC of the total money supply (M3) and indicates that the NASDAQ's performance is closely linked to the M3 growth rate, with changes in M3 often leading changes in the NASDAQ. When we showed this chart in early December both the M3 and NASDAQ growth rates were declining sharply. We now have a large divergence in that the M3 growth rate has exploded higher whereas the NASDAQ is yet to respond to the additional liquidity.

The above chart suggests that the NASDAQ is about to move sharply higher.

Below is a chart comparing the Fed Funds Rate (FFR) with the 12-month ROC of the S&P500 Index (shown in red). In the 1989-1992 easing cycle, a period during which the FFR was slashed from 9.8% to 3%, it wasn't until early 1991 that a substantial stock market rally erupted. In fact, during the first 18 months of the rate-reduction cycle the market essentially went nowhere. It did, however, climb 10% during the first 6 months of the cycle. We have specifically mentioned the 89-92 cycle because it began prior to the onset of a recession and may, therefore, be somewhat comparable to the current situation.

Cuts in official interest rates are not a cure for all financial ailments, but they are generally beneficial to stock prices. The potency of the recent rate cut, as far as its effect on the stock market is concerned, was potentially increased by the surge in money supply growth that preceded it.

Current Market Situation

It appears that the 2-3 week rally mentioned in the latest WMU has begun, although Yahoo's earnings disappointment could apply some downward pressure at the start of trading on Thursday. We think the market will absorb the Yahoo news and move higher over the next few sessions.

We do not think there is a short-term bearish case to be made for the stock market. Either a) we get a rally over the next fortnight, or b) the current rally falters immediately and the market declines into late January, setting the scene for a multi-month rally thereafter. Although alternative a) would provide some immediate gratification for the bulls, alternative b) would eventually yield higher numbers for the major indices. In both cases the NASDAQ Comp. and NASDAQ100 are likely to out-perform the S&P500.

If a near-term rally does occur, which seems highly probable, the subsequent correction would probably be gut-wrenching (for the bulls) but would not necessarily take the market to new lows. The monetary environment has become extremely positive (as noted above) and the sentiment picture, whilst not suggesting a major bottom, has certainly reached a level of negativity sufficient to support a substantial counter-trend up-move. In particular, the Consensus-inc sentiment survey (the survey that has proven to be the most reliable contrary indicator over the past few years) has just notched-up two consecutive 20% bullish readings (a level that is usually only seen at intermediate-term bottoms). Furthermore, the equity put/call ratio on Tuesday was 0.88, an extraordinarily-high reading for a day during which the market achieved a modest gain.

We will add one more depressed tech stock - Metricom (NASDAQ: MCOM) - to the Portfolio at $11-$12 (price to be determined based on Thursday's trading).

Gold and the Dollar

Judging by the reaction of the equity market, yesterday's plunge in the gold price and surge in the oil price were both head-fakes. The equity market is usually right about these things, but not always. The failure of oil stocks to react to the sharp rise in the oil price may be due to rising long-term interest rates (oil companies are capital intensive and their stock prices therefore tend to move with the bond market) or to the rotation of money from 'safety stocks' into the technology sector. In other words, it may be saying nothing about the future price of oil. Similarly, the ability of most gold stocks to hold their ground in the face of the recent sharp fall in the gold price may be related more to stubborn optimism than anything else.

The near-term picture for gold is uncertain. A short-term divergence is building between the bullion price and the prices of gold stocks that could be resolved by either a drop in the equities or by a quick rebound in the commodity price (on a longer-term basis, gold stocks are still extremely cheap relative to the gold price). At this stage the sell-stop associated with our short-term trading position in gold stocks (refer to the latest Weekly Update) has not been hit, so we will continue to give the bullish case the benefit of the doubt. 

The medium-term picture has certainly not changed and, in fact, has probably improved if our bond market analysis is correct. 

As noted in the Jan-09 Market Alert, a normal counter-trend bounce following the Dollar's recent slide could take the Dollar Index back to the 112-113 range before its down-trend resumes. Our minimum downside objective for the Dollar Index remains at 105.

Format Change

Beginning with the next Weekly Market Update (WMU) we will make a slight change to the format. At the top of each WMU we will put a table that includes a summary of our forecasts for the various markets on which we comment. For example, in today's Interim Update (IU) we have stated that the A$ should be one of the world's strongest currencies over the coming 12 months. This forecast will go into the table with a reference to the Jan-10 IU. If our view on the A$ subsequently changes, we will insert the new forecast into the table and also leave the old forecast in the table. Our current view/forecast will be shown in bold type. We are doing this so that:
a) As new subscribers come on board they can immediately see our current position on each market and can quickly refer back to previous issues to find out the reasoning behind those positions. 
b) To provide a greater level of accountability (the table will be an on-going report card).

Changes to the TSI Portfolio

MCOM will be added as noted above.