A month ago the big story was rising interest rates. Everybody was talking about how the economy was holding up while inflation was still a problem and so, far from cutting rates later this year, the Fed’s next move might even be to raise them! Yada Yada. That was the buzz back then.
I didn’t pay much attention to it because I knew, as has been apparent for at least a year, that housing was falling apart and that this would have a huge impact on consumer spending, jobs and hence the economy. The Fed would have to cut rates in response to the fallout. That’s why I asserted that the rise in rates didn’t mean they were going to the stratosphere, that we were range trading on the 10 year.
That post got cited in the WSJ’s Marketbeat. And it’s turned out to be dead on.
With the problems at the two Bear Stearns hedge funds invested in subprime mortgage CDOs, similar problems at other hedge funds and some recent problems getting LBOs financed, the rate on the 10 year closed below 5% yesterday (Fri 7/20) (10 Yr. 3 Month Chart). “It’s all on subprime, credit contagion and credit spread concerns,” said Maryann Hurley, vice president at D.A. Davidson.
In this context I want to recommend an excellent article from last Tuesday’s Financial Times by Ken Fisher. Fisher runs through a bit of recent history to demonstrate that widening spreads (between high quality and low quality debt) predicted stock market corrections in 1998 and 2000 and narrowing spreads a stock market rally in 2003.
These charts of the spread between treasuries and junk, 1987-2007, (from Steve Rattner’s timely and excellent WSJ Commentary “The Coming Credit Meltdown” (subscription required), Monday June 18, 2007) and the S&P 500, 1998-2007, bear this relationship out.
Fisher walks us through the history.
In 1998, spreads bounced around 350 basis points in the first half of the year. Then Long Term Capital Management blew up and ignited fears that the entire industry was infected. The spread ran up throughout the Summer of ’98 to almost 700 basis points (you can see exactly what he’s talking about in the chart – take a look) – and the stock market had a 20% correction.
Then the spread began to narrow and stocks recovered and continued up for the remainder of 1998 and 1999.
Fast forward to 2000. Fisher says the spread was 400 basis points at the beginning of 2000 (the chart looks like about 550) but then rose the entire year ending at 850 basis points. This foretold the nasty recession and bear market of 2001-2002.
Fast forward again, this time to 2003. As you can see from the chart, spreads were extremely high: over 1000 basis points towards the end of 2002. That’s when they started a dramatic downward move (a bull market for junk) over the next two years, getting well below 400 basis points by the end of 2004. Stocks correspondingly turned around and had a breakout year in 2003 – the start of the current bull market.
Could those Bear Stearns hedge funds be this cycle’s Long Term Capital Management?