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December 09, 2005
Fed Funds versus Stocks, The Yield Curve and Newmont's Trading Range
Do interest rates really matter? The NYSE Composite did just fine from 1995 to 2000 when the Fed Funds rate stayed mostly above 5%. It was not until the Fed Funds rate began falling that the NYSE Composite started falling (2001). This is a clear case of the stock market moving lower when interest rates also moved lower.
Why is that? The Fed lowers interest rates when it sees economic weakness. Even though lower interest rates translate into a lower cost of capital for businesses, it appears that the economic weakness argument has been winning lately.
The Fed Funds rate bottomed in Sep-03 and the NYSE Composite turned up a few months before this bottom. Both have been rising since Jul-04 (almost 18 months). The Fed raises rates when it sees signs of economic strength and the stock market does not seem to mind higher rates as long as they are tied to economic growth.
The first rises (1% to 4%) were the easy part as the Fed Funds rate returns to normal (~5%). The increases from here (4%) will bring the rate closer and closer to 5%, which appears to be neutral territory. As long as rates rise, we can assume that the economy is in good shape or that the Fed sees inflation on the horizon. It could even be a little of both as both gold and stocks move higher.
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Another way to assess monetary policy is with the yield curve. This is done by subtracting a short-term yield from a long-term yield. In this example, I am subtracting the 13-week T-Bill Yield from the 10-Year T-Note Yield. Long-term rates should be higher than short-term rates and this creates a normal yield curve. When short-term rates are higher than long-term rates, the yield curve is inverted and this is bearish.
In the last ten years, the yield curve has only been inverted once (Aug-00 to Jan-01). This coincided with a major top in the NYSE Composite. Currently, the yield curve is still normal and the Fed is tightening. You can clearly see that the spread between the 10-year T-Note Yield and 13-week T-Bill Yield has narrowed significantly over the last several months. Many bond market pundits are calling for an end to this tightening phase as the spread approaches zero. That remains to be seen, but one thing is clear: the direction is down and the trend favors more tightening. Unless inflation gets out of hand, the Fed is unlikely to push this spread below zero and produce an inverted yield curve. If gold is warning of a serious uptick in inflation, then this spread could turn negative and the Finance sector would be hit pretty hard.
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Newmont (NEM) has formed the mother of all consolidations. Since NEM first broke above 35, gold has advanced from below 400 to above 500. However, NEM remains stuck in a long-term trading range. Did NEM secretly hedge production? Probably not, but the stock is not keeping up with gold, which broke its 2003 and 2004 highs. NEM is current challenging resistance and a breakout at 51 would be hugely bullish. The pattern looks like a sharp advance and (20-50) and long flag (35-50). A break above 51 would signal a continuation of the prior advance and project a move to around 65 (50 – 20 = 30, 35 + 30 = 65). We could also consider the trading range a large rectangle formation and a breakout would project a move to around 65 (50 – 35 = 15, 50 + 15 = 65).
Posted by Arthur B. Hill at December 9, 2005 01:49 AM