Friday, February 18, 2005


Greenspan testified to congress that the extra low bond rates is a conundrum. I can help. The answer is simple.

In mid may, investment bankers bought 30 year bonds yielding 5.6%. The bankers borrowed the money at 1%. They earned a initial spread of 4.6%! A $1,000 bond purchased in May appreciated to $1,236 last week when yields hit the low of 4.2%; not bad! A gain of 23.6% in 9 months plus a nice spread all on borrowed money!

As with any mini-bubble, investors piled on near the end of the 9 month trend. Greenspan raised short rates 6 small steps but a decent spread remained through-out the move. Greenspan can never win in all eyes. In a similar environment in 1994, he was sharply criticized for raising .75% all at once. Never-the-less, by raising rates 6 consecutive months he did remove hyper inflation fears and he slowed an economy that was showing signs of over-heating. His increases, encouraged the bond move that naturally started with the 30 year, included the 10 year and by the last week or so even included the 5 year.

By last week, investment banks knew the market had over-shot just the same as it had at 5.6%. Bankers sold into the move. Economic numbers show that Greenspan's tightening still has not slowed the economy all that much. Industrial production is on a run and the latest unemployment claims are very low at 302,000.

Greenspan stayed on message during his testimony. He did not want to spook the market by saying. "Oops, I am still well be hind the curve and the market has finally figured it out". Early on, he did say that he expects rates to continue to move up toward equilibrium. He said he will know equilibrium when he sees it. Of course, equilibrium is a moving target. Both components, inflation and growth are influenced by many factors. Equilibrium will continue to be reached like a stopped clock, on a pendulum swing to the other side.

Have the markets confirmed the story I just told? Absolutely; it all makes perfectly good sense.

Look at the action the past several days.

1. If short rates are still too low, then the dollar should be weak. The dollar is falling again.
2. If short rates are too low, then gold should be rising. Gold turned a few days ago.
3. If short rates are too low, long rates should be moving up. Long-rates turned a few days ago.
4. If short rates are too low, interest sensitive stocks should be down. Even in the face of a Circuit City bid, retailers have pulled back. Banks are down. Utilities (take out the natural gas plays) are down.
5. If short rates are too low, economically sensitive stocks should be up. Take a look at energy, natural resources and even small caps for the past few days.
6. If short rates are too low, the yield curve should be steep. After flattening for months, the curve has steepened.
7. If short rates are expected to rise, stocks should struggle. Stocks have had a real nice three week run but took it on the chin today.

I will probably buy a gold stock or two later this morning. No one should chase every little swing but testing the old highs without breaking out would be a decent trade.


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