Tuesday, April 12, 2005

WSJ.com - U.S. Home Trade Deficit

WSJ.com - U.S. Home

"Lions and Tigers and Bears, O MY!" The alarm bells have been rung again! The trade deficit set a new record. Oh how wonderful it is! Americans have wealth and are buying goods cheap! The best news is that the "bad news" adds to the wall of worry that the market is about to climb.

The following are a few relationships that are true but often misstated or misunderstood. They tell a lot of the story but not the whole story.

1) There is an inverse relationship between commodity prices and bond prices.

2) There is a positive relationship between stock and bond prices.

3) There is and inverse relationship in US Dollar prices and commodity prices.

The continuing trade deficit implies that the US Dollar price is still too high. The dollar price is to a large degree determined by relative interest rates. Money always flows to where it is paid the most. In other words if US interest rates are high, demand for dollars is high as investors seek the highest return. If the dollar is too high, the pressure to raise interest rates in America is lessened. Indeed the relationship left out of the list above is the positive relationship between interest rates and the trade deficit. Yes, the higher the trade deficit goes the lower our interest rates are likely to be!

You don't have to believe me, just look at a comparative chart of interest rates and the trade deficit since 2000. At the start of the decade, the treasury yield curve was very flat; the five, ten and thirty year notes were all yielding between 6.7 and 6.9%. Since 2000 the trade deficit has soared but interest rates have gone down.

Looking from a longer term perspective, the US current account was in balance in 1984 and interest rates were very high. The long-term treasury yielded 13.75%. We have been in a 21 year down-trend in interest rates and a 21 year uptrend in the trade deficit. For the past few months it looked like the trend had finally turned. The increase in the trade deficit announced today shows that interest rates do not need to go higher. The slow growth in Europe and Japan imply that those countries should stimulate their economies and lower interest rates further--giving the US even more room to lower rates. This is good news for stocks, bonds, and real estate.

One of the nuances to the list above is in regard to the positive relationship of stocks and bonds. This is another relationship that acts like the positive relationship between oil prices and airline stock prices. The relationship is true in the "long middle" but one leads the other and much of the time the two trade opposite of each other as far as short term moves. Most of the time, when the money supply starts to tighten, it is the bond market that gets hit first but the stock market follows. For example, by the time the stock market turned in March of 2000, the bond market had already been hit hard.

The bottom line is that the news today is good but perceived to be bad. The focus will most likely be on the inverse relationship of the Dollar and commodity prices. This will give the gold bugs, oil bugs and other hole diggers something to wax-on about. Gold and oil will likely trade higher for a while. Note again the decline in the dollar from 2001 to last year. This was not a bad time for stocks. The decline in the dollar lead the way but for much of the time the markets were going up while the dollar was going down. The weaker time has only been after the dollar firmed.

Buy the Big Bull because the Boom and Bubble will follow! Make sure you don't wait for the Bubble to get in because if you do you may get in just in time for the Bust. Do the Google Gulp!