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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The opportunity to lock in a real, or inflation-adjusted interest rate is one of the great innovations of modern finance. The question of timing one’s decision on buying and selling, on the other hand, is subject to all the usual pitfalls regardless of the security in question.
Fortunately, historical context sometimes offers a touch of enlightenment, as illustrated by the recent track record of the 10-year yield on the 10-year inflation-indexed Treasury, or TIPS as they’re commonly called. As the chart below illustrates, higher yields have come to those who wait. Or so the last few months suggest.

Buying a 10-year TIPS as of last night’s close delivered a real 2.37% yield. That’s near the highest in several years. In fact, last Friday’s trading closed with a 2.43% TIPS yield, the highest since September 2003. That’s a nice improvement over the TIPS yields of under 1.7% as recently as last September.
The question, of course, is whether locking in a real 2.37% yield now is sufficiently enticing for weathering the future. Or, might there be even higher real yields available in the weeks and months ahead?

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Finance theory counsels that riskier asset classes carry greater volatility in their prices, a profile that necessarily spills over into returns as well. Stocks are more volatile than bonds, to cite the obvious example, and so the former tend to deliver higher returns compared with the latter over time. Unfortunately, finance theory doesn’t tell us what to do, if anything, when and if those relationships are thrown out of whack. That’s where common sense and the survival instinct fill in the gap.
Indeed, some of the volatility relationships these days may be deviating from terrain that some might recognize as typical. Nowhere does the atypical stand out more so than in the world of real estate investment trusts relative to the competing asset classes, as the following chart reveals.

In particular, the volatility for REITs leads the other major asset classes. (Volatility here is measured by the trailing 36-month standard deviation of monthly returns through March 2006.) Higher volatility implies higher risks. The question is whether REITs are deserving of their top-of-the-hill status as the most volatile asset class?
There are no absolutes for answering such matters, although one could make an argument that better candidates for the top volatility spot, using history as a guide, are commodities, emerging markets stocks and high-yield bonds. REITs, by contrast, are a fairly stable lot and not necessarily deserving of the current label. Some might even argue that REITs really aren’t a high-risk asset class at all. Perhaps, although you wouldn’t know it by look at REITs these days.
It’s worth considering that the driver of the relatively high volatility in REITs is related to the fact that the asset class has been in a bull market for some time. To be precise, you have to go back to 1999 to find calendar-year red ink for the Dow Jones Wilshire REIT Index. In every year since, REITs have taken wing. And so far this year, the party rolls on, with the index up by 10% in 2006 as of yesterday’s close.

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The economy’s on a roll, or so we’re told. The latest smoking gun is Friday’s employment report. Even the bond market appears convinced that there’s more growth percolating than previously realized. In turn, the bubbling labor market inspires fears of higher inflation among traders of debt. Reflecting the sentiment, the yield on the 10-year Treasury jumped sharply on Friday, closing at 4.96%. The last time the 10-year explored such yield heights, in the summer of 2002, Greenspan’s Fed was losing sleep over deflation anxiety.
The opposite risk now threatens. That, at least, is the new new message from the fixed-income set. But while some say it’s about time the bond market woke up, a few lone voices in the financial wilderness warn of something else, namely, the possibility that a slowdown may be lurking just over the horizon, and so inflation may not be lurking in the shadows after all.
In the interest of exploring how the other half thinks, we called one of the leading analysts who’s braving the headwinds of contrarianism at this juncture: Lakshman Achuthan, managing director of the Economic Cycle Research Institute, an independent research shop in New York. ECRI’s forte is one of applying a disciplined, quantitative analysis to the economic data in search of identifying turning points in cycles. On that score, this respected shop points to two warning signs at this moment, Achuthan tells The Capital Spectator. Housing and the global industrial sector may surprise with weakness, relative to the crowd’s current expectations, he advises. What’s more, Achuthan says that ECRI’s widely monitored FIG, or future inflation gauge, is counseling that inflationary pressures will soon wane.
Given the bullish economic news of late, some may be inclined to dismiss such forecasts. But ECRI is not just another forecasting shop. Indeed, it has an impressive record in calling turning points in the economy, thanks largely to a methodology that’s one of the more intelligently designed systems for discerning the future. For details on the methodology, which leverages decades of cycle-oriented macroeconomic research, ECRI’s book Beating the Business Cycle will satisfy. For a quicker fix on ECRI’s current take on what may lie ahead, here’s an excerpt from our Friday conversation with Achuthan.
Q: We keep reading that the economy’s doing fine. The bond market certainly seems to be throwing in the towel after seeing the strength in the March employment report. And that follows other numbers in previous weeks suggesting that the economy has a head of steam.
A: That’s an ok view near term. I wouldn’t argue with anything you just said for the next month or two or three. But once we get into second half of 2006, that logic falls apart.

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Another day, another set of data points that underscore the notion that the economy is doing fine. The Labor Department this morning released the March Employment Report and, once again, there were fresh numbers showing the labor market’s death has been widely exaggerated. Does this mean that the forecasting ability of the inverted yield curve in weeks and months past has been proven to be something less than useful?
In any case, the unemployment rate last month dipped again, down to 4.7% in March, the lowest since July 2001. “Businesses are regaining confidence to the point where they are now actively hiring new workers,” Lynn Reaser, chief economist at Bank of America’s Investment Strategies Group, tells AP via MSNBC.com.
Meanwhile, the economy generated 211,000 new nonfarm payroll jobs last month, which translates into a roughly 1.5% increase in March over February. Although that’s below the stellar days of the late 1990s, it’s near the upper range that’s prevailed in recent years, as the chart below reveals. More importantly, the rate of payroll increase has been holding steady. Below average is one thing; but below average growth that prevails over time adds up to something.

It’s also worth noting that the bulk of the job gains in March came from the service sector, which is by far the largest chunk of the economy. In other words, the main cyclinders of the American jobs machine is firing away.
If the economy’s headed for a slowdown, or worse, the broad labor numbers aren’t betraying much in the way of an early warning sign. Perhaps that’s why the yield on the 10-year Treasury is higher today. As we write this morning, the 10-year Treasury’s current yield is 4.93–the highest since June 2002, according to Barchart.com data.
Perhaps the bigger question is whether the spread in the ten year over the two year is set to widen. Predicting that outcome is on firmer ground these days, if only because the formerly inverted curve of the 10-year/2-year Treasuries has gone flat lately, as the chart below illustrates.

If the economy keeps chugging along, reasonable minds will agree that further adjustment toward a normal yield curve (i.e., one where longer maturities offer materially higher yields relative to shorter ones) is warranted. Nonetheless, what looks reasonable in the 21st century doesn’t always coincide with what Mr. Market ends up delivering.

Yesterday’s unexpected rise in the nonmanufacturing sectors of the U.S. economy delivered another blow to pessimists anticipating an imminent slowdown.
The Institute for Supply Management reports that its nonmanufacturing index rose to 60.5% last month from 60.1% in February. That’s well above the 59% reading called for by the consensus estimate. March’s reading also confirms the sharp rebound in February after January’s drop to 56.8%, a dip that gave short sellers in the stock market a momentary burst of optimism.
But it’s getting tougher to see the glass half empty rather than half full. Indeed, the service side of the economy (which dwarfs the manufacturing component) is expanding at a healthy clip. What’s more, its broad based. “Thirteen of 17 non-manufacturing industry sectors report increased activity in March, compared to 10 that reported increased activity in February,” ISM’s press release advises.
Nomura Securities’ chief economist in New York, David Resler, yesterday observed in a note to clients that the ISM nonmanufacturing index’s rise last month “is well above its six-month average and signals a broadening expansion in the services sector.”
More encouraging news on divining the future for growth comes this morning by way of the weekly update on jobless claims. Initial claims for unemployment insurance dipped below 300,000 again for the week ended April 1, the Labor Department reports. That’s down by 5,000 for the week, and 47,000 below the year-earlier figure. If a broad economic stumble is coming, it’s not evident in the jobless claims numbers.
Ditto for the so-called continuing claims for unemployment, a series that dropped to its lowest levels in the week through March 25 since January 2001, as the chart below illustrates.

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As the first week of the second quarter unfolds, telecom stocks remain the clear leader among the big-cap equity sectors. For the year through April 4, the S&P 500 telecom sector is up more than 14%, or three times above the S&P 500’s rise in 2006. Even energy, which remains hot but in second place, hasn’t been able to keep up, posting a 10.6% rise so far this year.
The lone sector that’s lost ground thus far in 2006 is utilities, which backtracked ever so slightly. That’s hardly surprising, given that this is an interest-rate sensitive sector and the price of money continues to rise.

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The bond market is finally paying attention to the 21 months (and counting) of ongoing rate hikes engineered by the world’s most powerful central bank. It took a while, but the Fed seems to have grabbed the attention of the fixed-income set to a degree that’s more than transitory. Maybe. But if the aura of higher short rates is beginning to take a toll on the long end, the gold market looks inclined to stay skeptical on what it all means.

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