Monday, April 25, 2005


Yield Curve--Spencer England's Review (click picture to enlarge)Posted by Hello

I have failed to find internet information about Spencer England's Review, other than the chart posted on The Big Picture by Barry Ritholtz. I am not familiar with Spencer's work but the above chart is an excellent picture of the history of our economy. I hope to see more of this excellent work; a good economic chart is worth 10,000 words. The article that follows this one includes a link to Barry's excellent site, The Big Picture.

The red line above is a plot of the yield differential between the 10 year treasury and the fed funds rate. This past Saturday, I posted a study done in 1996 showing how well the yield curve forecast economic growth. The above chart demonstrates an even tighter relationship when one adjust unemployment for the inflation rate (the black line).

I plan to spend at least a couple of hours relating this chart to the turning points in our economy. A quick look reveals that the two indicators are coincidental in nature. There are times when each leads the other. This means that when there is a divergence, then one can count on an adjustment to one or the other to bring them back into balance. The adjustment might be coming in the bond market or in the economy. You may not know which but at least you can approach that market with caution. At the current time there is no divergence, both indicators are forecasting 2% inflation adjusted growth which is not bad at all.

There have been many a time in my life that I have been able to take full advantage of a divergence. For example, after leveraging Treasury Bonds heavily in 1984 and making a wonderful return, a divergence occurred in the late fall of 1986. There were tax law changes that forced banks to sell municipal bonds. There was much confusion in the markets and many predicted that the law changes were about to cause long rates to rise dramatically. Holding millions of long bonds on margin, I was understandably very nervous. The solution was simple.

The crazy thing was that suddenly long municipal bonds yielded more than the long treasuries, before adjusting for the tax advantage! I sold the treasuries and purchase tax free bonds. Over the coming months the municipals appreciated significantly in value. Long rates really did not change very much but tax free municipals regained a health price differential over the taxable bonds, what a sweet trade!

The key point to take from this chart today is that current levels of these indicators are positive. The economy is in good shape. The recent sharp drop in unemployment claims might normally cause one to worry but ironically the current big concern in the market is that the economy is slowing too much. The commodity price bubble has basically broken and Nervous Nellie's are worrying over inflation and slow growth at the same time. The term for slow growth with high inflation is stagflation. Greenspan and I laugh at those expressing this concern. The economy is hitting on all cylinders. Whenever Greenspan is able to take his foot off the brake, the markets are going to take off!

Buy the Big Bull Boom Bubble that is coming! Beware the Bust that is about 4 or 5 years away!