actually use the D-word, the Fed signaled that it was ready to lower interest rates again to ward off the threat of falling prices (which is deflation). Thisstatement marked a major shift in Fed thinking, albeit a late one. It alsomarked the first time since World War II that a Fed Board had announced thatdeflation was a greater threat than inflation. The Fed started lowering rates inJanuary 2001 just after the record expansion of the 1990s had ended and a newrecession was starting. By May 2003, it had lowered rates 12 times to the lowest level since 1961. The fact that the most aggressive easing in 40 years couldnot stop the persistent drop in inflation should have sent off warning alarmsin the investment world much earlier than it did.Deflationary warning signs had already started to show up the previousyear. In December 2002, a negative Producer Price Index (PPI) number of–0.3 percent was reported for that month. Core wholesale prices (as measured by the PPI) fell 0.4 percent for the year, which was the first time in 28years that the United States had experienced an annual decline in wholesale
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prices. Economists took comfort in a small jump in the Consumer PriceIndex. What kept the CPI from falling throughout 2002 was a 3.2 percent risein the prices of consumer services. The prices of consumer goods in 2002actually fell 1.5 percent. The combined drop in the cost of goods duringNovember and December of 2002 was the biggest decline on record goingback to 1958. While economists were looking at inflation in medical costs andcollege tuition, American companies were being bled by deflation in manufactured goods.By the spring of 2003, the Fed’s preferred measure of inflation—the priceindex of personal consumption excluding food and energy—had fallen to1 percent. This was the lowest level of this measure in 40 years. Within 2 weeksof the Fed’s expression of concern about a “substantial fall in inflation,” itwas reported that April 2003 PPI numbers had fallen by 1.9 percent, whichwas the biggest monthly decline on record. A lot of that had to with the bigdrop in energy prices after the start of the Iraq war. The core PPI number(excluding food and energy) fell 0.9 percent, however, which was the biggestdrop in nine years. A day later it was reported that the Consumer Price Index(CPI) fell 0.3 percent in April. Its annual increase of 1.5 percent was thesmallest since 1966.From October 2002 to April 2003, the CPI core inflation rate was an evensmaller annual rate of 0.9 percent. Suddenly, the desired goal of zero inflationhad gotten dangerously close to slipping into an undesirable state of deflation. Later in May 2003, a special International Monetary Fund task forcewarned of a high and increasing risk of deflation in Germany, Taiwan, andHong Kong—and of worsening deflation in Japan.Low inflation means that prices of goods and services are rising at a relatively slower rate. Deflation means that prices are actually falling. In such aclimate, companies are not able to raise prices. As a result, they are forced tocut operating costs, translating into less hiring and more unemployment.Deflation is much more difficult to stop than inflation, especially with shortterm interest rates already at 1.25 percent. With rates so close to zero, theFed loses one of its main weapons against economic weakness and deflation:the ability to lower interest rates. This brings us back to the dollar.
LETTING THE DOLLAR FALLThe reaction of the financial markets to the Fed’s sudden fear of deflation(combined with deflationary CPI and PPI numbers) in May 2003 was pre-
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dictable. The yield on the 10-year Treasury note fell to the lowest level in45 years. The dollar fell to a four-year low against the euro, a five-year lowagainst the Canadian dollar, and a three-year low against the Australian dollar. (Money flows out of low-yielding currencies and into higher-yielding currencies. In May 2003, the U.S. two-year Treasury note yielded 1.5 percent. Bycomparison, the two-year note was yielding 4.61 percent in Australia, 3.69percent in Canada, and 2.4 percent in Germany.)Although the Fed could not lower rates much more, there was somethingelse they could lower: the dollar. A falling dollar is one of the best cures forfalling prices; it is usually considered to be inflationary. Some observers suspected that the Fed (and the U.S. Treasury) had been allowing the dollar tofall since the start of 2002 in an attempt to create a little inflation. This suspicion was confirmed a couple of weeks after the Fed issued its deflationwarning when Treasury Secretary John Snow hinted that the U.S. government had abandoned its eight-year policy of verbally supporting a strong dollar. Mr. Snow commented that the U.S. Government no longer measured thevalue of the dollar by its market value against the other major currencies.Traders took this as a sign that the government wanted the dollar to fall inorder to reflate (or reinflate) the economy. One place that this strategyworked was in the commodity pits. Immediately after Mr. Snow’s comment,traders sold the dollar and bought gold. By that time, however, commodityprices had already been rising for over a year, thanks to the falling dollar. Theplunge in yields in May 2003 proved to be short-lived. Within three months,higher commodity prices started pulling long-term rates higher and T-bondprices lower.
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CHAPTER 9
Falling DollarDuring 2002Boosts Commodities
COMMODITIES INFLATEThe previous chapter mentioned the Fed’s sudden concern about deflation inMay, 2003, and the U.S. government’s abandonment of its strong dollar policy. The plan was to sacrifice the dollar in an attempt to boost prices. By thetime the Fed noticed that prices were falling, commodity markets hadalready been rallying for over a year. A lot of that had to do with the fallingdollar. The rise in commodities, however, did not have the normal impact onbonds. As mentioned earlier, one of the major intermarket relationships thathad changed since 1998 was the link between bonds and stocks. During thesecond half of 2002, another key intermarket relationship changed: the linkbetween bonds and commodities.Rising commodity prices during the second half of 2002 should have produced lower bond prices and higher bond yields. They did not. One possibleexplanation for the decoupling of bond yields and commodity prices is thepresence of global deflationary trends. U.S. rates are linked to global rates,which tend to rise and fall together. With Japan still mired in a deflationarydecline, global interest rates continued to drop together. This global deflationary influence helps explain why bond yields did not follow commodityprices to a higher level during the second half of 2002. Falling stock pricesalso kept a lid on interest rates. A closer examination of the individual commodity markets that led the CRB Index higher in 2002 also provides a clue tothe lack of response on the part of the bond market.
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CRB IndexMA(50)MA(200)
230.0COMMODITY PRICESHAVE BEEN RISING
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A FALLING DOLLAR IS BULLISHFOR COMMODITIES
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Throughout 2002, the falling dollar coincided with rising commodity prices.
DOLLAR PEAK COINCIDES WITH COMMODITY BOTTOMThe U.S. dollar hit its final peak during the first quarter of 2002. From thatpoint on, it dropped sharply for the balance of that year. The CRB Index(which represents a basket of commodity markets) turned up at the exactpoint that the dollar peaked. For the rest of 2002, commodity prices continued an uninterrupted advance. This action is consistent with the intermarketprinciple that a falling dollar usually results in higher commodity prices (seeFigure 9.1). In the previous chapter, we discussed the rally in the gold marketas a result of the falling dollar. The fact is that the commodity rally spread tomost commodity markets, not just gold.
BONDS AND COMMODITIES DECOUPLESuch a strong rally in commodities should have put downward pressure onthe bond market in 2002. This did not happen. During the first half of 2002,bond and commodity prices maintained their normal inverse relationship.Commodities bounced while bonds pulled back. Starting at mid-year, how-
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15.0%
CRB Index30-Year US Treasury Bond Price
12.5%10.0%7.5%5.0%2.5%0.0%-2.5%-5.0%-7.5%-10.0%-12.5%© StockCharts.com 2003
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Bond and commodity prices trended in opposite directions until the middleof 2002.
ever, commodities turned sharply higher. This would normally have produced lower bond prices. Surprisingly, bond prices started rallying rightalong with commodities, as shown in Figure 9.2. Part of the explanationfor the rise in bond prices comes from the fact that the stock market resumed its bear trend in the spring and summer of 2002; bonds rallied as aresult. It seems that the bond market was more closely correlated withstocks during 2002 that it was with commodities. Part of the reason whybond traders ignored the commodity rally also lies in which commodity markets did the rallying.
WAR PREMIUM PUSHES OIL HIGHERThe direction of crude oil prices has an important influence on the directionof the CRB Index. A comparison of the two markets shows a close positivecorrelation from 2000 through 2002. Oil had peaked during the second half of2000, then dropped until the end of 2001. The CRB Index peaked shortly afteroil and also dropped throughout 2001. Both markets turned up again at thestart of 2002 (aided by a falling dollar) as shown in Figure 9.3. Although the
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CRB IndexOil - Light Crude
40.0%30.0%20.0%10.0%0.0%-10.0%-20.0%
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FIGURE 9.3
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One of the reasons the CRB rose during 2002 was the war premium builtinto oil prices.
price of crude rallied throughout 2002, it was suspected at the time that anunrealistic and unsustainable war premium was being built into its price inanticipation of another war with Iraq. In other words, the oil rally was somewhat artificial and probably temporary. (This proved to be the case early in2003 when crude prices tumbled more than 33 percent shortly after the Iraqwar started.) It is also true that rising oil represents a tax on the economy andhas the unfortunate result of slowing prospects for economic growth. Slowereconomic growth results in lower interest rates and higher bond prices.Instead of sending off inflation alarms in 2002 and causing lower bond prices,rising energy prices may have had the opposite effect.
COMMODITY DIVERGENCE:WEATHER VERSUS THE ECONOMYThe biggest gains in the commodity markets during the third quarter of 2002actually came from the grain markets. Drought conditions in the U.S. Midwestcaused agricultural markets to soar. This in turn gave a big boost to the CRBIndex. At the same time, however, industrial metal prices were actually drop-
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Agricultural Prices - Goldman Sachs Commodity IndexIndustrial Metal Prices - Goldman Sachs Commodity Index
15.0%10.0%5.0%0.0%-5.0%-10.0%-15.0%-20.0%© StockCharts.com 2003
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FIGURE 9.4
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During the second half of 2002, weather problems pushed agricultural priceshigher while industrial metals fell.
ping. The commodity markets were sending a mixed message, one which wasnot lost on the bond bulls. Bond prices—and interest rates—react to the economic message being sent by commodity markets. A commodity divergenceexisted during the second half of 2002. Agricultural markets, which react toweather conditions, were rising. Industrial metals, which react to economicconditions, were not. As a rule, grain markets have much less of an influenceon interest rates than the price of copper. All it would have taken to stop thegrain rally was a little more rain. It would have taken a much stronger economy, however, to push industrial metal prices higher. Part of the explanationas to why bond bulls were not concerned about a rising CRB Index in 2002was based on the belief that the rally in the CRB Index was giving a false signal of economic strength. History seems to support this view (see Figure 9.4).
INDUSTRIAL METALS AND INTEREST RATESTREND TOGETHERIndustrial metals and bond yields peaked together at the start of 2000, signaling an economic downturn and a stock market peak. For the next three
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years, both markets fell together, as shown in Figure 9.5. In an earlier chapter, we discussed the fact that industrial metals (like aluminum and copper)are considered to be barometers of global economic strength or weakness.Rising industrial metals are associated with stronger economic conditions,as are higher interest rates. Falling industrial metals are associated withweaker economic conditions and lower interest rates. There is a tendencyfor industrial metals and interest rates to trend in the same direction. Bothrebounded together during the fourth quarter of 2001 (after the September11 tragedy). By the spring of 2002, however, industrial metals and interestrates started falling again, as did the stock market. Interestingly, all three—industrial metals, bond yields, and the stock market—bottomed together inOctober of 2002. It appears that bond traders were more concerned with theweak economic signals sent by falling industrial metals and falling stockprices in 2002 than they were with the lack of rain in the Midwest. (By thesummer of 2003, industrial metals had become the strongest commoditygroup and began to exert upward pressure on long-term interest rates.)
35.0%
10-Year T-Note YieldIndustrial Metal Prices - Goldman Sachs Commodity Index
30.0%25.0%20.0%15.0%10.0%5.0%0.0%-5.0%-10.0%-15.0%-20.0%-25.0%
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FIGURE 9.5
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Both lines peaked together at the start of 2000 and fell togetherthrough 2002.
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COMMODITY PRICES AND BOND YIELDSNORMALLY TREND TOGETHERAny chart comparison of bond yields and commodity prices shows that theynormally trend in the same direction. Bond yields and the CRB Index peakedtogether in 1996 and dropped until the end of 1998. (Much of the decline fromthe middle of 1997 to the fourth quarter of 1998 resulted from deflationary fearsin the aftermath of the Asian currency crisis.) The CRB Index and bond yieldsrose together throughout 1999, which ultimately led to the stock market peak in2000. Bond yields and commodities diverged in 2000; this happened as interestrates fell and commodities rose. This divergence was apparently caused by amassive flight to bonds following the Nasdaq market collapse. By 2001, bondyields and commodity prices were back in sync as they fell together. It was notuntil the middle of 2002 that they started to diverge again (see Figure 9.6). Thisbook has already offered some possible explanations for the bond-commoditydecoupling during the second half of 2002, due to the nature of the commodityrally and the fact that stocks were falling sharply. There may also have been aglobal explanation for the continuing drop in bond yields.
CRB Index
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COMMODITY PRICES AND BOND YIELDSNORMALLY TREND TOGETHER
260.0240.0220.0200.0
30-Year T-Bond Yield
85.080.075.0BOND YIELDS DIVERGEFROM THE CRB INDEX
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FIGURE 9.6
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After trending together since 1995, bond yields and the CRB started todiverge in mid-2002.
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ASIAN DEFLATION PULLS U.S. RATES LOWERSince 2000, a remarkably close correlation has existed between the yield onthe 10-year U.S. Treasury note and the Japanese stock market. Japan was theworld’s second largest economy and had fallen into a deflationary spiral offalling prices. (After the Asian currency crisis of 1997, these deflationary tendencies spread to the rest of Asia and eventually the rest of the world.)Because global markets are so closely linked, the deflationary trends exported from Asia had the effect of pulling down interest rates all over theworld. This included U.S. rates. After falling together throughout 2000 andmost of 2001, the Japanese market bounced—along with U.S. bond yields—after September 11, 2001, and continued to rise together into the spring of2002. During the April–May 2002 period, both markets started dropping again(as did the U.S. stock market). By August 2002, the Nikkei had fallen to a 20year low, while U.S. bond yields had dropped to the lowest level in 40 years,as shown in Figure 9.7. It could be argued that global deflationary trendscoming from Japan continued to pull U.S. interest rates lower during the second half of 2002 and offset the impact of rising commodity prices.
10-Year T-Note YieldTokyo Nikkei Average
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Asian deflation caused U.S. rates and Japanese stocks to fall together startingin 2000.
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GLOBAL BEARGlobal linkages play an increasingly important role in the intermarket chain.Global interest rates rise and fall together. The same is true with stock markets. It should come as no surprise, then, to find out that the bear marketwhich gripped the U.S. stock market in 2000 was global in scope. In otherwords, all of the world’s major stock markets fell together. No part of theworld escaped unscathed—not Asia, not Europe, and certainly not the UnitedStates. The fact that world stock markets were so closely correlated to thedownside for three years is another dramatic example of how world marketsare linked (see Figure 9.8).The fact that global markets tend to fall together also bolsters the argument against global diversification during a big bear market. The idea ofputting some of one’s funds overseas to escape a falling U.S. stock marketdoes not work during a global bear market. It also shows why it is so important for us as investors to know what is going on outside our own borders.U.S. markets are very much affected by global trends. If global stocks arefalling, this usually means that global economies are weakening as well. If
S&P 500 Large Cap IndexGerman DAX CompositeHong Kong Hang Seng
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World markets were closely correlated to the downside from 2000 to 2002 ina dramatic example of global linkages.
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global economies are weak, who is going to buy American goods? If the American economy is weak, who is going to buy the goods of foreign countries whodepend on exports to survive? In addition, the fact that global stock marketsfell along with global interest rates also suggests that something drove all ofthem lower. Japan seems to be the logical candidate.
JAPAN PULLING WORLD MARKETS LOWERAs previously stated, there is a close correlation between the Japanese stockmarket and U.S. bond rates. This was done to make the point that deflationin Japan was primarily responsible for pulling U.S. rates lower (not to mention global rates). The same comparison can be made with global stock markets. A comparison of the Japanese stock market with an index of globalstock markets also shows a remarkable correlation (see Figure 9.9). Hereagain, both peaked at the start of 2000 and fell together for the next threeyears. Throughout this three-year decline, even the intermediate peaks andtroughs are closely matched. Both indexes bottomed during the fourthquarter of 2001 and rallied into the following spring. At that point, all rolled
25.0%
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World stocks followed Japan lower because of deflationary tendencies.
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over to the downside together. (By the end of 2002 most global stock marketsstarted to stabilize and rallied together throughout most of 2003.)
DEFLATION SCENARIO: U.S. STOCKSAND RATES FALL TOGETHERThis brings us back to the U.S. bond and stock markets. There is a reason whywe discussed global trends before returning to our study of U.S. markets. Itwas to simply make the point that the unusual relationship between U.S. bondsand stocks since 2000 seems puzzling only when looked at simply in U.S.domestic terms. A comparison of stock prices and U.S. interest rates since2000 shows them falling together (see Figure 9.10). When markets do not follow their usual intermarket pattern, it is because something unusual is happening. At some point, the intelligent analyst has to start looking for reasons.Major decouplings of bonds and stocks normally take place in a deflationaryenvironment. The last example of this happening was during the 1930s.American economists, and Wall Street in general, held to the mantra thatthe United States was not actually in a deflation and all the market neededS&P 500 Large Cap Index10-Year T-Note Yield
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The deflation scenario explains why bond yields and stocks fell togetherfrom 2000 to 2002.
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was another Fed easing. Japan was already in a deflation, however. TheJapanese had lowered interest rates to zero with no apparent effect on theirstock market or their economy. The Fed had lowered rates 12 times to thepoint where they were getting dangerously close to zero. U.S. bond yieldshad fallen to the lowest level in over 40 years. The Japanese stock market hadfallen to the lowest level in 12 years. Japanese consumer prices had beenbelow zero for 3 years. By the spring of 2003, U.S. core consumer prices weredown to 1.5 percent—the lowest level in 40 years. All of these comparisonsstrongly suggest that the deflationary trend that started in Japan was largelyresponsible for the major decoupling of U.S. bonds and stocks over the pastthree years, as well as most of the other changes in the traditional intermarket model. The markets anticipate the future. Although the U.S. marketshad not actually fallen into a deflation, the markets clearly saw trends moving in that direction. Anticipating trends are what the markets—and charts—are all about.
COMMODITIES GAIN FROM BATTLE AGAINST DEFLATIONLet us end this chapter where we began—with rising commodity prices. Afalling dollar is normally considered to be inflationary. The collapsing dollarsince the start of 2002 had already started to push commodity prices sharplyhigher. By the end of 2002, the CRB Index had risen to the highest level in fiveyears. This rise in 2002 might be interpreted as an early sign that the fallingdollar was already starting to have the desired effect of creating some commodity inflation. This is good news for commodity traders. If the government is willing to let the dollar drop, it can only boost commodity markets.If the Fed is preoccupied with deflation, it will be reluctant to raise interestrates. This is also bullish for commodity prices. Ironically, this makes commodity markets the biggest gainers from the Fed’s battle against deflation.
DOLLAR TOP LEADS TO NEW BULL MARKET IN GOLDOne of the major tasks of chart reading is to determine if a trend change isonly a relatively minor one, or if it represents a major shift in the direction ofany market. One of the ways to incorporate intermarket analysis into the picture is to compare the chart action of two related markets. First, one simplycompares their direction to see if they are following the normal pattern.
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120.0
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By the end of 2002, the Dollar Index was breaking a seven-year support line.
Recall that a falling dollar is bullish for gold. If gold is starting to rise, the firstthing to do is to determine if the dollar is starting to drop. The next thing todo is to look at the separate charts of each market to determine the importance of their respective trend changes. A minor trend change in one may notjustify a major trend change in the other. Their trend signals should be of similar magnitude.The U.S. dollar had been dropping throughout 2002. At the same time,gold prices had been rising.