Rising Yield Curve, Shift in Global Demand and the Gold Oil Ratio

``Everything is new if you are ignorant of history. That is why ideas that have failed repeatedly in centuries past reappear again, under the banner of ‘change,’ to dazzle people and sweep them off their feet." Thomas Sowell

As expected, we are witnessing anew the resurgence selling pressures in the financial markets as the global credit markets continue to manifest incredible strain of tightening liquidity signified by soaring interest rates of various benchmarks such as the credit default swaps of several US financial institutions trading at the highest level ever, yield spreads of US agency owned mortgaged backed securities at highest level since 1986, auction rate bond failures hit 70% as brokers and bankers withhold financing, distressed debt levels rose to its highest level since August 2003 as investor’s flee to safehaven assets, Euro zones interbank rate hit its highest since January 18 exceeding ECB’s policy rate, yield spread between 10 year German bunds and the Italian bond surged to a decade high, sales of emerging market bonds fell 65% and the a significant 21% decline in derivative trading the first time in 14 years.

This comes even prior to the US Federal Reserve’s meeting which is due on March 18, with market expectations of a Fed cut of possibly at least 50 basis points priced presently into the Fed futures market.

Nonetheless, the tensions in the credit market has successfully percolated into the equity markets as the turmoil in some hedge funds, asset liquidation by several companies aside from major repricing of companies experiencing mortgage problems, as the suspension of Carlye Capital Corp of its mortgage bond funds, suspension of investor redemption in several hedge funds, liquidation by mortgage lender Thornburg Mortgage of assets to raise capital, aside from a growing consensus of the US undergoing a recession prompted for massive liquidation across the board.

Figure 5 from Prieur Du Plessis’ Investment postcard emphasizes on the steepening of the yield curve which has exhibited a strong historical inverse correlation with the directional activities of the S & P 500.

Figure 5: Prieur Du Plessis/Stockcharts.com: Inverse Correlation of S&P 500 and the 10-year/2 year yield curve

A steepening of the yield curve has coincided with downside volatility in the S&P 500. Notes Mr. Plessis, ``The above analysis is merely one cog of the wheel, but seems to point to more downside for US stocks. However, be cognizant of the fact that the stock market is a discounting mechanism and often starts moving higher before a reversal of the yield curve (see 2002/2003). It may still be a while before we reach this stage, and investment portfolios should in the meantime emphasize capital preservation rather than opportunistic trades.” (highlight mine)

But of course even as the financial markets remain under renewed pressure of heightened volatility, commodities continue to march upwards mainly in the face of a record breaking decline of the US dollar, signs of growing emerging market domestic demand and redistribution of wealth.

Yet we gathered some important insights of how rising commodities could affect different regions of the world aside from the subtle changes in the way trade and wealth redistribution has been conducted of late as shown in Figure 6.

Figure 6 Danske Bank: Soaring Commodity prices bring shift in global demand

Danske Bank’s Chief Economist Steen Bocian observes that while stagflationary (stagnant growth and rising inflation) tendencies are being reinforced in the euro zone, there are important implications for global trade (underscore mine), ``For countries that export commodities and energy, rising commodity and energy prices are synonymous with rising real income. What we see in the global economy is not just higher inflation, but also a marked redistribution of purchasing power as expressed by movements in the terms of trade.

``The Middle East, Africa, CIS countries and Latin America have seen massive improvements in their terms of trade at the expense of the EU, the US and Asia. To some extent this is also reflected in global demand. Take Japanese exports, for example. The EU and the US together are no longer contributing to Japanese export growth. While Asia is still making a healthy contribution, the big change is that the rest of the world is carrying more and more of the load. This group consists mainly of countries which have seen improvements in their terms of trade. In January these countries accounted for almost half of Japanese export growth.”

Aside from the empirical evidence shown by the shift in trading composition of Japan’s trading partners, this redistribution of purchasing power tilted towards emerging market commodity producers seems to be a fitting explanation or perhaps a proximate reason why, despite the present pressures in the global financial markets, some equity markets appears to have ‘decoupled’ especially seen in Middle East and African equity benchmarks as Oman, Nigeria, Bahrain, Morocco Egypt and Kuwait which are trading at fresh record highs unaffected by the global tensions, while Jordan, Qatar, United Arab Emirates, Kenya, Tunisia and Namibia are at spitting distance from new record highs.

We notice the same phenomenon in some of Latin American bourses such as fresh record territory of Costa Rica’s benchmark and near record highs too in commodities heavy exports of Brazil, Bermuda and Jamaica.

The decline in Asian markets likewise appears to validate this stagflation view of rising commodity prices negatively affecting some of the region’s economy, if we base this on the recent performances of its benchmark. But our guess is that this should apply mostly to countries with insignificant natural resources exports. Indonesia among all of Asia appears to be least impacted by the recent tensions as its bellwether the Jakarta Stock Exchange remains at striking distance from its previously established highs.

So for the moment it simply isn’t true (yet) that the ongoing deflation in some vital parts of the world is likely to drag the whole globe into a deflationary morass as some depression advocates argue. For as long as commodity prices persist to benefit from the falling dollar, growing emerging market domestic demand and the redistribution of purchasing power from commodity importing countries to commodity suppliers we are likely to see the same phenomenon continue if not accelerate.

The same argument should likewise keep the Philippine Phisix from suffering a similar fate. As investments pile on into our resource industries, e.g. mines expects some $892 million from last year’s $605 million (inquirer.net) agriculture based biofuel investments from Spain Php 16.2 billion (inquirer.net) and from some companies in the US worth $55 million and $200 million (inquirer.net, manilastandard.com) or agriculture investments by China for food exports (chosun.com) and investments from UAE meant for Halal food for exports to the Middle East (khaleejtimes.com), commodity exports are likely to gain substantial market share relative to total exports and provide the unexpected support to our GDP. (Our agriculture experts can’t even seem to even make this call or perhaps are not yet convinced of these developments.)

That is why we remain long term bullish with resources related companies, simply because resource based industries are likely to benefit from the purchasing power shift which has been benefiting commodity exporters around the world.

Finally, we recently got a comment concerning which among the two major commodity bellwethers (gold or oil) appears to be more “pricier” relative to current prices.

I guess the gold oil ratio should determine this as shown in Figure 7.

Figure 7: US Global Investors: Gold Oil Ratio at Critical lows

With oil trading at inflation adjusted record high at over $105 and gold at just under $974, the 36 year chart gold-oil courtesy of US Global Investors posits that gold today buys 9.6 barrels of oil compared to its long term average of 15 barrels. This suggests that gold is relatively undervalued when compared to oil.

But as a caveat, John Derrick of Global Investors notes that gold has risen by 2 standard deviations during the last two months which has reflected similarities to the present performance of the yen relative to the US dollar.

What it means? From John Derrick (highlight mine), ``The dollar has fallen against other major world currencies and is nearing an extreme low condition, which historically suggests that a bottom could come soon. If the dollar bottoms out and then starts rising, a reversal for gold will likely follow given that these currencies tend to move in opposite directions.”

Well such is premised upon the condition that gold follows the inverse trajectory of the US dollar. But this correlation has not been strong or has not always worked under the same pattern; in 2005 both gold and the US dollar rose.

Our assumption is for as long as major central banks conducts efforts to “socialize” losses, we are likely to see rising gold relative to all currencies But we should give Mr. Derrick’s insight the benefit of the doubt since overbought levels are likely to result to cyclical profit-taking.

Remember, no trend goes in a straight line.