Response to Muckdog and Random Roger: Yield Curve Inversion.

Muckdog and Random Roger have noted the recent yield on the 2 year at 4.39% and the 10 year at 4.37%. The following is my response to their discussion.

At the risk of sounding like "this time is different", I must say that there are a lot of things that used to be true that are no longer true. In the old days, a dramatic down-turn in autos was a sure sign of pending recession. A slow down in housing was even more ominous.

Now-a-days, the economy is much more resilient because it is a service based economy, less dependent on cyclical industries.

Another major change between the old days and now-a-days is that more and more loans are variable rate loans. "The glass is half empty crowd" seizes on variable rate loans as another reason "the recession" is going to be rough. As usual, economic variables do not correlate well with markets; at the very least, there is a time shift. A simple but great example is that one should buy cyclical stocks when earnings are low, not when earnings are at their peak. The market is already discounting the day when rate increases stop. Smart investors are buying the transportation index and other strong business cycle stocks while rates are still on the rise.

While theoretically consumers have been hit hard by 13 increases in short rates, the economy has been resilient. Suddenly, the higher rates are finally slowing record home sales. For five or six weeks in a row, fixed rate home mortgage rates have come down. Thus, by the time sales are down, the market is already adjusting to make houses more affordable.

The important reason the yield curve is flat is because long rates will not go up! Long rates, clearly have sniffed out declining inflation rates and are lower now than when short rates were lower.

The inference to draw is that with autos and housing experiencing a slow down, long rates will continue to trend down. The FOMC is facing declining inflation, a slow-down in autos and a slow down in housing. The pressure is on to stop raising short rates. Indeed, the Bank of England is reported to be considering a rate cut.

On February 1, 1995, during a similar mid-cycle correction, the FOMCmade the last increase in a string of rate increases. Only 5 months later, on July 6, 1995, the FOMC was forced to make the first of several rate cuts.

Gold and oil have hit highs and lost momentum; in 1995, Gold continued to trade up a little when the FOMC was forced to cut rates. However, Gold started a very long plunge the following year. Oil has recently traced out a classic head and shoulders top. I see odds building of downward movement. I happen to agree with about 85% of the forecast made by my friends at haysadvisory.com (subscription required). This year, oil supply growth relative to oil demand growth was the strongest since 1998!

One of my most valuable market "secrets" has been reinforced by the wise words of Ken Fisher as published in Forbes Magazine. He reports that if you can find a "true fact" that is widely disbelieved, you can make a lot of easy money. To be specific, oil production grew by 1.25 million more barrels than oil consumption during 2005, the second year in a row of excess production and the best result since 1998! If you want to track the energy markets closely, I suggest you subscribe to the WTRG Economics service produced by James Williams. He believes natural gas will be pushing down on $10 early in 2006.

Oil industry forward earnings projections will turn-down if energy prices continue to correct. So, we will have one more block built in our wall of worry and another reason for a short-term stock sell off, and, another reason for long rates to decline.

Housing is levered to long interest rates. Housing will catch on fire again if mortgage rates keep coming down. Many an American now wants to own a vacation home or two as the best way to get a visit or two from the grandkids. The majority of Americans, having done a poor job investing in stocks, know that first, second, and even third homes are great investments.

During the first half of 2006, I will not argue against the idea that a slowing of GNP might occur. After all, who can expect a blistering 4.1% real rate to continue? However, without total idiocy by the FOMC or a terrorist attack on US soil, I see no recession in sight.

With mortgage rates down 5 weeks in a row, with a record number of Americans turning 60 and with American family wealth exploding upward, you can count on heavy buying of second homes in 2006. With the highest levels of inheritance occurring in history (the Bob Hope generation is fading fast), you can count on housing upgrades by the recipients.

Barry put up a great chart on his Big Picture Blog that shows the declining influence of the inverted yield curve. In the old days, the curve predicted something like 10 of 8 recessions. It is about to miss again.