What Will The Inflection Point Look Like?

October 9, 2009

A client asked the following question above ….

Jim, yes, same page, “inflection” point = March rally over. I missed the conf call so you may have touched upon it. Will have time to review this weekend. I think you believe rally is over when Fed “pulls” liquidity, i.e, rate high, etc. Rate hike = $ positive = correlation w/equity still holds. I am wondering if we’ll see $ down, equity down before the rate hike thus breaking the $ down, equity up correlation. Catalyst ? Something similar to yesterday’s 30-year result or another Independent-like article. The catalyst causes Dixie to move lower and equities head for the exit. Is that scenario probable ? Thanks.

First as we noted above,

Looking at the issue from a larger viewpoint, we addressed the correlation between stocks and currencies in a Special Report earlier this week

We concluded, with:

First, the relationships between individual currencies and U.S. equity indices are both short-term and unstable in nature. Second, the widely held supposition the large-capitalization stocks of the Russell 1000 index are more sensitive to currency changes fails to pass muster.

So, we don’t put much stock in the currency/stock relationship. It is unstable. It works until it does not and you don’t know when it stops working.
Second, as the three panel chart below shows, the total returns of stocks and bonds have been positively correlated for about 12 years (bottom panel). The chart below that shows the 1-year and 3-month correlations. Unlike currencies/stocks, this is a far more stable relationship.
Why did this relationship flip in 1997? As we detailed in in our September Conference Call:
The takeaway from these charts is that, once the Productivity Miracle was accepted in the late 90s, and Greenspan said we could run interest rates much lower than we normally would, the relationship between stocks and bonds inverted. The stock market is driven by carry, like so many other asset markets. So, low short rates (which often occur with a steep curve) drive stocks higher and higher short rates (which often occur with a flatter curve) drive rates lower.
Our guess is that this relationship ends at the inflection point. In other words, interest rates will rise as stocks fall, marking a return to the pre-1997 correlation. The market fears the end of carry which drives stocks down. The reason carry is ending is the market is so afraid of inflation, they demand the Federal Reserve drive rates up.

<Click on chart for larger image>

<Click on chart for larger image>

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