16January2006

Special report: interest rates

I posted a chart a couple of weeks ago and didn't make any mention of it. The chart is entitled: "US Treasury Curve: 10-year yield less 2-year yield". It's a chart published by the Federal Reserve displaying the spread, in basis points, between long and short term rates for the past 30 years. You have probably heard the terms; "flattening yield curve, and inverted yield curve" kicked around recently. The concern is this: for the past 30 years, whenever the yield curve has inverted there has been a recession. And, we are currently approaching and inversion. Check the chart: yield inversions.
In the summer and fall of last year, you probably also heard the FED Chairman Alan Greenspan talking about the interest rate conundrum, (a paradoxical, insoluble, or difficult problem; a dilemma). What he meant by that, was that the FED has been racheting up interest rates at regular invervals since June 30, 2004: 1/4% at a time. Thirteen increases in a row! As the FED continued to raise rates, long term rates continued to decline. They started declining in April, 2004. I just completed a quanitative analysis of the 30-year Bond market from 1988 to the present using OEW. And, the conclusions that I have drawn may add some light to the 'conundrum' paradox and the potential 'yield inversion'.
From October 26, 1981 until recently; Bond prices have been rising because interest rates have been in a major Supercycle bear market. The the 30-year bond rate peaked on that day at 15.21%! It closed on friday at 4.525%. At the recent low in June, 2005 interest rates had declined 72%, top to bottom. Similar to the Supercycle decline in the Nasdaq 2000 - 2002, which was 78%.
According to my analysis, from late 1994 until the recent low in mid 2005, interest rates were in the process of completing a complex double three: an ABC followed by another ABC. In this particular situation it was an ABC zigzag from late 1994 to late 1998, followed by a X wave into early 2000, then an ABC flat into the recent low in June, 2005. At the time that the FED decided to start raising rates only the A and B waves of the flat were completed. Interest rates needed to decline again to retest the lows of mid 2003 to complete the flat. So effectively the FED was fighting the unfolding of the Elliott Wave. Since investor psychology is not a local event, but a worldwide consciousness. It didn't matter what the FED did, the wave needed to complete. Thus, Greenspans 'conundrum' was basically an unawareness of what was transpiring in long term rates. It is possible, however, that if the FED did not raise rates when they did, the ABC could have unfolded as an ABC zigzag instead, and rates could have fallen significantly below 4%. So they might have had some effect.
I'm posting two charts that display this bear market unfolding. The first chart is BOND1988: a monthly bar chart displaying the ABC-X-ABC portion of the bear market. The second chart is BOND2002: a weekly bar chart displaying the flat formed at the June, 2005 low; and the subsequent advance since that low. Now that the conundrum is understood, lets move onto the potential yield inversion.
What creates a flattening yield curve or actual inverted yield curve is when short term rates are rising faster than long term rates. Eventually, if short term rates continue to rise quickly monies come out of debt investments and move into short term treasuries for a better return with a shorter time span. As the monies moves out of debt into treasuries, bond prices decline and the spread widens again. However, what is important is the time factor involved. If this takes too long to unfold, or becomes a continuous pattern, the credit availablity for investment will tighten: i.e. mortgages, corporate capitol investment, etc. When this happens an economic recession follows. The recession is caused by a tightening of investment credit. Credit is still available, as it was before, but banks and investors are lending with a shorter time horizon.
I have concluded, based upon OEW analysis, that the 24-year Supercycle bear market in interest rates ended in June of 2005. Since that low, we have had two impulse waves: the first from late June - early Aug, a correction, and then another impulse wave stronger than the first, from late Aug - early Nov. See chart: BONDdaily. The market is currently in the process of correcting this second impulse wave. Since the first wave was not a kickoff to a bull market like we often see in stocks, but a gradual climb, I've labeled it major wave 1 of primary wave I. The second advance, which was stronger, but it's correction is overlapping major wave 1, I've labeled minor wave i of major wave 3. Thus, we have effectively a 1 - 2, 1 - 2 coming off the recent Supercycle bear market low in June, 2005. To confirm this bull market, I expect like to see a 5% long term yield by as early as this spring. So one can state that I'm not only bullish on stocks, but now also bullish on interest rates. As for the potential inverted yield curve. It is still possible. There are other factors on the horizon, other than the FED that could cause short term rates to continue to rise. I'll cover that at a later time. Best to your holiday shortened week!