The 10-year Treasury yield surged yesterday while the stock market sagged. The threat of higher long rates (the 10-year’s nearly 5.1% yield is the highest in four years) is becoming reality, weighing on equity and bond traders alike. But in keeping with the times, the long-anticipated rise in long rates arrives just as a cloud of debate descends over what the Federal Reserve is planning for monetary policy in the coming months.
The central bank may not be the most transparent institution on the planet, but few have been surprised by the continual string of 25-basis-point rate hikes that have prevailed since June of 2004. The absurdly low 1.0% Fed funds rate was last seen on June 29, 2004, a day before the FOMC declared it defunct by way of a quarter-point rise to 1.25%. The Fed has been making similar declarations ever since, and so Fed funds now stands materially higher at 4.75%.
The next opportunity for a declarative statement on monetary policy from Bernanke et. al. comes on May 10. Expectations for another 25-basis-point hike are baked into May Fed funds futures, but there’s also a rising tide of prediction that the tightening may be the central bank’s last for some time.
We emphasize “prediction” because this particular moment is proving to be tricky when it comes to deciding when the Fed will cease and desist with its rate hikes. Arguably, the main catalyst for expecting an end to the tightening will be a material slowdown in the real estate market. But by what definition will “slowdown” be decided? And when?
Whatever the answer, real estate is a sector that’s received a laser beam of focus recently over whether the bull market in home prices is a bubble threatening to burst until and if the central bank intervenes with sentiment-shifting incentives, i.e., higher rates. In fact, there’s been some recent evidence that the housing market has been cooling, if only marginally. But turning points in real estate, Fed policy, or any other economic/financial trend are rarely crystal clear, and the transition in housing from boom to something less is proving to be no less wily, and so the cloud of unknowing may be spilling over into the outlook for Fed policy.

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Emerging Markets stocks are comfortably in first place in the performance race among asset classes so far this year through April 24. No, let’s rephrase that: Emerging markets are flying. The MSCI Emerging Markets Index, based in dollars, has climbed a stellar 19% year to date. Even small-cap stocks, another hot performer with a 14% rise so far, are having a hard time keeping up this year through last night’s close.
Meanwhile, bonds of various types dominate the opposite end of the return spectrum. Among the dozen investment types we track here, inflation-protected Treasuries (measured by the Vanguard Inflation-Protected Securities Fund) have lost 2.3% year to date. A broader measure of U.S. bonds, via the Lehman Aggregate Bond Index, is off fractionally. This year is proving to be relatively tough sailing even for U.S. high yield bonds, which have climbed 3.3%, according to the Merrill Lynch High Yield Master II Index.

Indices/Funds: MSCI EM ($), Russell 2000, MSCI EAFE ($), MSCI REIT, S&P 500, DJ-AIG Commodity, ML HY Master II, 3-mo T-bill, Pimco EM Bond Fund ($), Lehman Bros. Aggregate, Pimco Foreign Bond ($), Vanguard Infl Prot Sec
Stocks, in other words, are enjoying a bull market this year. The riskier, the bigger the payoff in the land of equities. Expecting the party to end has been a losing proposition so far in 2006. Contrarians might expect that the good times will soon end, but looking for warning signs amid valuation ratios offers a mixed bag.
According to S&P/Citigroup Global Indices, emerging markets overall look only slightly pricey to world equities based on dividend yields and the price-to-sales ratio for data as of March 31. In contrast, emerging markets are a modest bargain if you compare them to the world stocks by way of the price-to-book, price-to-cashflow, or trailing 12-month price-to-earnings ratios.
There are other threats that could derail the party in emerging markets, but the obvious ones that can be sliced and diced in spreadsheets are for the moment fairly benign. That may be false comfort, but in the meantime upward momentum is still the path of least resistance. But the hour is late. Caveat emptor!
© 2006 by James Picerno. All rights reserved.

On Friday, the Commerce Department unveils the government’s first estimate of economic growth for this year’s first quarter. The consensus outlook calls for a hefty rise of 5.0%, according to Briefing.com. If that proves accurate, the optimists will no doubt celebrate the rebound from the dismal 1.7% rise logged for the fourth quarter. Indeed, 5.0% would be the fastest quarter growth since the 7.3% advance in 2003’s third quarter.
Meanwhile, the shadow from the previous number still looms. The fourth-quarter GDP report, you may recall, sent shivers throughout Wall Street and Main Street. The sky was finally falling, and recession loomed, or so it appeared from the sharp slowdown posted in the last three months of 2005 vs. the previous quarter.
Statistically, who could argue? The thin 1.7% advance in real GDP for the fourth quarter was a world below the 4.1% climb that prevailed during July through September. But as we wrote back in January, when the fourth-quarter number was initially released, there were more than a few skeptics claiming disbelief that the economy could be as weak as the Commerce Department said it was. A modicum of justification for the doubts came with each of the two subsequent 4Q GDP revisions. Once the numerical dust cleared, the 1.1% rise in GDP first reported migrated upward to the final 1.7%.
Still, 1.7% doesn’t suffice to keep the pessimists at bay. The task of regaining optimism’s commanding heights necessarily falls to the shoulders of this Friday’s 1Q GDP number. If the consensus holds, the coming weekend promises to be one when cries of “I told you so” echo throughout the land.

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Is the economy slowing or isn’t it? As always, there are competing views and conflicting data. That doesn’t stop some from making predictions, including Lakshman Achuthan, managing director of the Economic Cycle Research Institute, who advised in an interview with CS last week that the first-quarter bounce would give way to something less impressive in the second half of this year.
Adding support for Achuthan’s outlook is yesterday’s update on the Conference Board’s leading index, which posted a slight decline last month. That comes after a larger drop in February. But even this downward bias of late, which implies slower growth in the months ahead, isn’t quite the negative it appears to be.
“Despite the weakness in the leading index in February and March,” the Conference Board said in a press release yesterday, “its six month growth rate picked up to an average of 3.2% annual rate in the first quarter, up from an average growth rate of 2.7% in the fourth quarter, which was higher than its average growth of 1.8% in 2005.” In addition, five of the ten indicators that make up the leading index increased in March.
Ok, so is the economic glass half full or half empty? One could make a case for either, although today’s release of survey results from the National Association of Business Economists leans toward the glass-is-half-full view. “Results of the April NABE industry survey suggests continued economic growth but with somewhat greater price pressures,” says Ken Simonson, chief economist, Associated General Contractors of America, in a press release accompanying the survey, which reflects the views of 116 economists who are NABE members.

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China President Hu Jintao is in Washington today to chat with President Bush about matters large and small. Firmly entrenched in the former category is oil, the mother of all strategic topics for the countries at the top of the world’s energy feeding chain.
China, as everyone on the planet surely knows, has a large and growing thirst for crude. That thirst arguably will be quenched only by way of a dramatic shakeup in the market for the world’s most valuable commodity and more than a little turmoil on the world’s geopolitical and military stages. The Bush White House expects no less. Reflecting that sentiment is the observation (warning?) to China that it can’t stay on a “peaceful path while holding on to old ways of thinking and acting that exacerbate concerns throughout the region and the world,” according to the National Security Report issued last month by the Bush administration. The “old ways” are defined in the report as follows:
* Continuing China’s military expansion in a non-transparent way;
* Expanding trade, but acting as if they can somehow “lock up” energy supplies around the world or seek to direct markets rather than opening them up – as if they can follow a mercantilism borrowed from a discredited era; and
* Supporting resource-rich countries without regard to the misrule at home or misbehavior abroad of those regimes.
Repricing oil upward to reflect such tensions, in other words, is the order of the day. The 21st century’s version of the Great Game, and it’s being played out around the world. One recent skirmish unfolds as we speak in Central Asia, the site of the original Great Game.
Given this backdrop, it’s not exactly shocking to learn that the price of crude was trading above $72 a barrel this morning in New York futures trading–yet another all-time high. That’s a fitting greeting for President Hu’s arrival in Washington. The increase in oil consumption in the Middle Kingdom far exceeds the pace of domestic production, as the chart below shows. That’s a big deal for the world’s fastest-growing major economy, which is second only to the United States in petroleum consumption.

Source: CBO

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In the land of textbook economics, a central bank takes away the proverbial punchbowl when the party threatens to spin out of control. The removal convinces the partiers to cool their jets. In time, the central bank rewards everyone by returning the punchbowl, thereby planting the seeds to launch a cycle anew.
Nothing’s quite so simple in 2006. In fact, much of what professors like to teach in economics 101 is up for debate. Take the punchbowl, everybody’s favorite central-banking metaphor for easy money. This basin of liquidity injection was delivered in earnest a few years back. Predictably, the presence of cash sloshing around the system ignited bull markets far and wide. Evidence can be found everywhere, with the repercussions continuing to the present. It’s hard not to find an asset class that’s not running skyward these days. As a sampling, here’s a slice of what’s unfolded so far in 2006, through yesterday:
Large-Cap Stocks: +5.24% (S&P 500)
Small-Cap Stocks: + 14.68% (Russell 2000)
REITs: 10.03% (Morgan Stanley REIT)
Commodities: +8.17% (Oppenheimer Real Asset Fund)
10-year Treasury: +1.12% (10 Year Constant Maturity Treasury)
Junk bonds: +2.98% (ML US High Yield Master II Index)
The Federal Reserve is of course currently engaged in a gentle effort to remove the punchbowl with minimal fuss. In fact, one might argue that the Fed has been attempting to elevate interest rates but without affecting investor perceptions, which is a bit like trying to trying to discipline Rover and hope that he still retains his old habits. But even the central bank’s subtle effort may be nearing an end, if yesterday’s release of minutes from the Fed’s March 27-28 FOMC meeting are an indication. “Most members thought that the end of the tightening process was likely to be near…” the minutes advised.
San Francisco Federal Reserve president Janet Yellen brought the thinking of the March minutes into the here and now in a speech yesterday by voicing concerns of “the policy tightening going too far,” via TheStreet.com.

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Gold and oil don’t have much in common. The former, which is almost never consumed, is generally admired in one form or another for eternity; the latter is destined for a relatively short life after extraction from its natural environs. There is one exception, though. Gold and oil share an infamous link: inflation.
Gold is the medium that historically has offered a hedge against inflation. Oil, if its price rises high enough and stays elevated long enough, is said to be a primary driver of inflation at a rate above and beyond what central banks consider acceptable.
The value of the link as a window on the future, like most relationships where money’s concerned, is open to debate. Empirically, this makes perfect sense. The instances of twin bull markets in gold and oil that’s also accompanies by rising inflation are relatively rare. The last clear example came in the late-1970s and early 1980s.
So, where’s the relevance? In the eye of the beholder.

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Today is tax day in the U.S. Show your postmark, or file an extension. Meanwhile, be thankful that the IRS has extended the filing deadline to April 17, or two days beyond the traditional April 15, courtesy of the 15th falling on a Saturday this year.
The tax man may be willing to wait an extra 48 hours for his money this year, but rest assured he’ll settle for nothing less than the usual take in the end. Unfortunately for taxpayers, the usual take is on the rise again, based on the Tax Foundation’s newest calculation of “Tax Freedom Day.” This is the day that the average American taxpayer has earned enough to pay for his taxes, based on a measure of national, state and local taxes. For example, if tax freedom day is April 1, wages for the first three months of the year go to pay the various levies imposed by governments for the year.
In 2006, Fax Freedom Day comes on April 26, according to this year’s Tax Foundation study. “Tax freedom will come three days later in 2006 than it did in 2005,” Tax Foundation President Scott Hodge advises in a press release, “and fully 10 days later than in 2003 and 2004 when a combination of slow income growth and tax cuts caused Tax Freedom Day to arrive comparatively early, on April 16.”

Source: Tax Foundation

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Cole Porter confessed that he received no kick from champagne. Even alcohol delivered no thrill. The stock market is equally unmoved by a different and decidedly negative tonic known as interest rates. Bulls of earlier generations felt differently. The question is whether today’s optimists can maintain their cheery outlook even in the face of a more determined assault from a bond market that’s newly inspired to reprice and revalue?
In particular, the benchmark 10-year Treasury Note closed above 5% yesterday for the first time since June 2002. If that was a warning shot across the stock market’s bow, it was a minor milestone received with a flurry of buy orders among equity traders. Although the S&P 500 has slumped this week, it managed to eke out a small gain yesterday even as the 10-year yield crossed north of 5%.
Year-to-date, the S&P 500’s price is higher by 3.3%. Meanwhile, the small-cap S&P 600 is up an impressive 10.5% so far in 2006. Perhaps the stock market dreams of bulls conjured by comments like those espoused by Fed Board Governor Donald Kohn. Yesterday, he suggested in a speech that the central bank’s recent monetary tightening may suffer from irrational exuberance as it tries to restrain the effects of excess liquidity that the Fed unleashed a few years earlier. “Overshooting is one of the things we are very aware of as a risk in policy today,” Kohn said on Thursday in a response to a question after a speech, reports Reuters.
Risky or not, the Fed is now enthused about cutting off any emerging inflationary pressures in the bud. Whatever the risk of going overboard with rate hikes, for the moment they seem to pale next to the hazards that some think could ensue by ending the monetary tightening. The futures market, for one, all but predicts that the 25-basis-point hikes will continue in coming months, in which case the current 4.75% Fed funds would elevate to 5.25% and perhaps beyond. If so, the bond market, now that it’s found monetary religion, presumably would keep pushing the 10-year higher. Flat yield curves, it seems, are in danger of becoming déclassé among the fashionably minded fixed-income set this season.

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Commodities may be the new new thing, but life in the financial world isn’t doing so badly either. In fact, financial stocks have enjoyed a strong run in recent years. The question is whether things can get any better for finance?
For the moment at least, it’s easy to say that more of the same is coming, a perspective that finds support by looking in the rear-view mirror. For the year through last month, for example, the S&P 500 Financials Spider ETF (XTF) ranks second in performance among the nine sector Spider ETFs, posting a total return of 17.1%. Only the S&P 500 Energy Spider (XLE) boasts a better record over that 12-month stretch, rising by 28.3%.
Delivering above-average gains at a time when interest rates are rising is no mean feat for financial stocks. In theory, an industry that thrives on cheap money should be hurt when liquidity starts to fade. But evidence in support of that textbook notion is scarce. Indeed, XLF has recently been making new highs–hardly the sign of anxiety about the future.
What’s more, Wall Street expects the robust earnings rise in financial stocks to continue for the foreseeable future. AltaVista Independent Research, an ETF-focused shop, points out in its latest report to clients that “financial earnings are the fastest growing of any [S&P 500] sector in 2006.” The good times are predicted to continue in the second quarter, for instance, with XLF’s year-over-year percentage change in earnings forecast to rise 10.5%, according to the consensus outlook. That represents a respectable third place in relative terms, coming after energy’s expected 17.6% rise and utilities’ 17.5%.
None of this comes as a surprise to the bulls. Wall Street, after all, has rewarded financials past record handsomely. Financials remain by far the biggest slice of the S&P 500 sectors in terms of market cap, representing more than one-fifth of the benchmark.

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