Flattening Yield Curve, Soaring US Dollar Leads Phisix, Peso Lower

Flattening Yield Curve, Soaring US Dollar Leads Phisix, Peso Lower

The turn of events have turned sour to my optimistic projections this week as the Phisix (-3.52%) succumbed to a correction as well as with the Philippine Peso’s huge setback down by.72% or back to the P 56 levels at 56.045.

Because your analyst is predisposed to take his views from the 35,000 feet foot level, we will examine how the region performed compared to the Philippines. According to Bloomberg’s Kevin Cho, ``The Morgan Stanley Capital International Asia-Pacific Index, which tracks more than 1,000 stocks in the region, lost 1.8 percent to 104.41, the biggest decline since the five-day period ended May 13.”

Only Pakistan, India, Japan and New Zealand recorded gains in a region plagued by losses.

Further, it appears that Asia’s currencies have also taken a hit, according to a report from Bloomberg’s Christina Soon, the Thai baht was down 1.2% to THB 41.31, the Singapore dollar fell 1.3% to S$1.6705, Taiwan’s dollar slumped .9% NT$ 32.189 and the South Korean won dropped 1.2% to KRW 1,025.70. While the Malaysian ringgit fell .42% to MYR 3.7665, the Chinese remembi/yuan was also down to .08% to CNY 8.1047, the Australia dollar down 2.7% to 75.14, as well as the Indian Rupee slightly lower by .1% to INR 43.583.

In short, ALL currencies in Asia across the board fell and the doldrums was likewise reflected in the performances of most of the Asian bourses.

According to almost all of the reports I read, including most local analysts higher OIL prices have been the major culprit…OIL, OIL, OIL.

Are these claims backed by evidence?

The following chart courtesy of stockcharts.com, shows that during the previous week the Phisix’s (candlesticks) rally was coincidental to the WTIC oil benchmark (red line) while this week the Oil benchmark fell almost simultaneously with the Phisix, except for Friday’s (Saturday-Philippine time) steep rally in the oil benchmark. So of all ironies, how can one claim that the almost synchronized declines in global equities were triggered by oil concerns?

This is exactly what in behavioral finance is called as the follies of rationalization or the process of constructing a logical justification using the du jour events from news headlines.

I’d like to bring the light on the next issue, the US dollar index. As you can see from the above chart, the US dollar index represented by the green line, whose correlation I have shown you last week, appears to be reinforcing itself. Did you notice that the recent top of the Phisix coincides with the recent bottom of the US dollar? This means that as the US dollar climbs, the Phisix loses its bullish momentum.

Aside from the losses of the Asian currencies, the US dollar index soared by 1.87% this week at the expense of the Euro (-2.17%), Yen (-.93%), Canadian Loonie (-1.31%), British Pound (-1.05%) and the Swiss franc (-2.16%).

In other words, in my opinion, it is the rebound of the US dollar index ACROSS the board or against most global currencies which has served as the causal factor behind the weakness in global equities more than oil concerns!!!

As can be seen in the above chart, courtesy of stockcharts.com, not only has oil and global equities, represented by the Dow Jones 1800 global equity benchmark (green line) weakened but so as with the emerging market bonds (red line) represented by the JP Emerging Debt Funds (-.22%), as well as the commodities benchmark represented by the CRB-Jeffries Index (candlesticks) which was down by 2.41%.

So what has caused the rally in the US dollar, one might be inclined to ask? Reports say that oil prices (again!) have raised inflation expectations, thereby prompting the US Federal Reserve to continue with its ‘measured’ rate of increases. In short, the currency markets focus may have shifted to the interest rate yield differentials once again.

However, if inflation was the concern, why then has US treasury yields been declining or US bond indices been rallying during the week? In fact, the yield curve has been flattening with the spread of the 2-year yield and the 10-year yield down by 2 to 20. And if the US Federal Reserve continues to raise its short term rates while long end of the curve remains at current levels the yield curve may eventually invert, raising the prospects of a US recession in 2006!

This flattening yield phenomenon reflects a monetary tightening environment and has diminished the arbitrage or ‘carry trade’ activities which has taken the fuel out of the global equity investing.

Given that foreign money preponderates on the investment activities in the Philippine Stock Exchange, with about 62.58% exposure for the week, I would suspect that the flattening of the yield curve has had significant effects on the latest retracement of the Phisix.

Although, foreign money still accounted for net inflows for the week to the tune of P 111.038 million, a noteworthy observation is that taking away the cross trades of Aboitiz Equity Ventures (-1.0%), the market could have turned negative relative to foreign capital flows. In fact, Thursday and Friday accounted for net foreign selling.

In essence, the Phisix languished as foreign activities shriveled or turned net selling due to the flattening yield curve more than oil concerns. The Peso which may have found a reason to correct on news accounts of ‘import season’ rationalities also fell victim to the global rise of the US dollar, apparently as capital flows streamed back to US dollar denominated bonds/treasuries, on the premise that the US Fed would continue to prop up its short term rates. I think Chairman Greenspan is targeting the ‘froth’ in the bubble-like boom in the US real estate industry and may find 2006 as a very challenging year for the US and global equities.

While high oil prices have been touted as the major cause of recent weaknesses, the financial market’s reaction appears to be telling otherwise. If indeed high oil is the cause of the weakness in Philippine stocks or the Peso, why haven’t the oil exploration companies share prices jump in line with higher oil prices, when they are essentially the INSURANCE to high oil prices? This does not make any sense.

As can be seen in the above chart, the three year chart of Dow Jones Emerging market Oil and Gas index have soared in tandem with oil/energy prices! I’ll repeat…oil companies are your insurance to higher oil prices.

So far, in my view, the US dollar rally this week constitutes a technical rebound, more than anything else. The near record high oil prices should drive the US trade deficit, which represents over a third of its imports, much higher and should structurally weigh on the US dollar over the long term.

Your prudent investor recognizes that the major risks to the world financial markets in the form of the US housing bubble, record level energy prices, the unstable US dollar and tightening monetary environment, and is keeping vigil over these developments.