ABSTRACT: A theoretical view of NOTES FROM UNDERGROUND is that the initial action of a flattening yield curve is BULLISH, or, most importantly, not BEARISH for a developed market currency for it signifies that a CENTRAL BANK is ahead of the inflation curve and thus, is given confidence by BOND BUYERS. The corollary to this premise is that flattening curves and certainly inverted curves are a BEARISH INDICATOR FOR EQUITY MARKETS. In a RISK ON/RISK OFF algo environment, the market continually reflects this, especially as we saw today. However, day-to-day trading strategies are certainly not the major test of the theory. A reader of the BLOG commented on Sunday’s post that the opposite view was what he believed. Again, theories are to be tested for trading like good science “ADVANCES ONE FUNERAL AT A TIME.” (Max Planck).
The question arose over the AUSSIE DOLLAR as its 2/10 curve has been steadily flattening and as of today closed at 36.8 basis points, which is very flat. As the curve has been flattening, the AUSSIE $ has been trading at recent highs even as many analysts have been touting the SHORT AUSSIE position as a surrogate for a slowing Chinese economy. In the early stages of flattening, the yield curve sends a signal that a central bank’s monetary policy is too tight and short-term rates need to lowered , which causes the front-end to rally. If the bank in question becomes too aggressive in its quest to steepen the curve, the long-end will be sold in the face of rate cuts, resulting in a BEAR STEEPENER.
If we look at the AUSSIE ALL ORDS stock performance over the last year, the INDEX shows that the flattening curve has made the Australian equity market a relative underperformer. My point in the NOTES was that the RBA should be cutting rates more aggressively to steepen the curve, unless of COURSE GOVERNOR STEVENS desires to slow the Aussie economy and credit growth with it.
This is not an easy concept and will require continued discussion amongst all the readers of NFU, but I will be assured of a major correction or the end of the PRECIOUS METALS BULL MARKET WHEN GLOBAL CURVES FLATTEN IN UNISON OR THE U.S. CURVE MOVES DRAMATICALLY FROM ITS PRESENT MODERATE STEEPNESS. (AN ASIDE: the AUSSIE GDP NUMBER WAS RELEASED TONIGHT AND WAS SOFTER THAN EXPECTED GIVING NOTICE TO THE RBA MAY BE TOO TIGHT.)
***In tomorrow’s Financial Times, there is an important column by Martin Wolf, “The Pain In Spain Will Test the Euro.” It is been the view of this BLOG that Spain is a far bigger problem than Italy. The private debt burden in Spain is a very serious problem in a country with 23% unemployment. Some analysts continue to float the idea the Spanish public sector was in far better shape going into the recession than even the Germans and Dutch, and, therefore, has the latitude to be more aggressive in stimulating growth. The proof for them is that the Spanish bonds were not as heavily sold off as the Italians, an indication the markets have far more confidence in the Spanish authorities.
My view has been that the ITALIAN BOND was under greater stress because it has a BTP FUTURES CONTRACT that became the “pissing post” for all hedgers seeking to protect any peripheral bond from downside risk. The WOLF PIECE gets into the issue of how the new STABILITY PACT put forth by the EU is fraught with error in dealing with STRUCTURAL DEFICITS. It is an enlightening piece.