FSO Editorials

Interest Rate Credit Pains

Are the Financials Feeling the Pain of a Flattening Curve? & What's Next for Bonds?

by Frank Barbera, CMT. September 30, 2005

Decline in Financial Stocks

Looking at the week just past, it is clear that financial stocks continue to weaken as was highlighted by the sharp decline mid-week in shares of Fannie Mae. In the stock market, the old saying goes that you only buy the exact bottom once and sell the exact high once in an investing career. To be sure, it is quite difficult to sell out near a major high or buy in at a precise low. Yet, from time to time, the action of a particular group can give clear insights relatively early on that a significant trend change is underway. Perhaps this information does not reveal itself on the exact day of a high, but usually, as prices begin to recede, the bearish bells and whistles begin to sound. That is exactly what is happening now with the Financial Sector where a number of highly-leveraged companies are feeling the pain of Fed interest rate hikes and a yield curve that has been flattening over the last two years.

Looking at the action of my Financial Index, I note that this unweighted index of 29 major financial companies, including companies with mortgage and sub-prime lending exposure, reached a double top over the last few months. [Note: For those interested, I include the names of all 29 stocks at the end of this article.] In the top chart below, one can plainly see that the unweighted financial index made a high on December 28, 2004 at 203.67 and then tumbled into a April low at 178.16. From that April low, the index then managed to move back up across the range to a slight new high on August 2, 2005 at a reading of 204.55. Importantly, as the index went to a new high on August 2^nd, the advance-decline line (bottom clip) for the financial stocks actually fell short of its equivalent December peak coming in with a high of 1611 on August 2nd, below the December 28, 2004 peak of 1656.

GST Financial Index: 2004 - 2005
Advance/Decline Line

This initial non-confirmation by the A/D Line has subsequently been followed with the A/D Line breaking below its 200-day moving average on August 18^th, which has now been confirmed with the index itself closing below its 200-day average over the last 2 days.

Is a trend change well underway? In my view, that answer to this question is clearly YES. In addition to the A/D Line, other technical gauges also point to more weakness ahead. Looking at the same index, with a similar measure of Cumulative Up to Down Volume, we find that over the last few days the volume curve has also closed below its 200-day average, which has been flattening out for months. Remember, volume is an important confirming indicator and often will lead price.

GST Financial Index: 2004 - 2005
Cumulative Up to Down Volume

Finally, momentum gauges for the Financials are also turning negative. As can be seen on the chart below, my medium term version of MACD (Moving Average Convergence-Divergence) is currently crossing down below its neutral line at 1.00. Note also that over the last two years as the financial index pressed ever higher, the MACD made a long series of lower highs, indicating consistent dissipation in upside momentum. With the index closing this week BELOW its 200-day average, THE trend change is at hand.

GST Financial Index: 2004 - 2005
Medium-Term MACD

As a result, if Financial stocks are actually turning down on a primary trend basis, the question must be asked, what factors could be underpinning the decline? To be sure, the steady stream of interest rate increases coming from the Federal Reserve over the last 2 years most certainly is one factor that could be pressuring financial shares.

2-Year - 10-Year Yield Curve
1995-2005

As we see in the chart above, the 2 Year -� 10 Year Spread has been narrowing steadily since reaching a peak in late 2003. This type of flattening yield spread can be very tough for financial companies where profits are tied to widening spreads (i.e. a steepening curve), not narrowing spreads (i.e. a flattening curve). While the current shape of the yield curve is very bearish for financials, one wonders whether or not there could be other factors also influencing the current decline in this sector? Afterall, financial stocks "being stocks" are by nature a forward-discounting mechanism and tend to be anticipatory in their trading patterns. Could there be other factors the financial stocks are anticipating, which could now be adding to the current decline?

Major Top for Mortgage-Related Sector?

In my view, I believe financial stocks could be anticipating a rise in long term rates, which would be especially bearish for the mortgage-related sector. Looking at some of the leading, highly-leveraged stocks in this area, I see chart formations, which spell out "Major Top." Just look at the chart on Golden West Financial, which has substantial exposure to a portfolio of Adjustable Rate Mortgages and Interest Only Loans.

Note that as the shares pressed higher over the last 2 years, Medium Term MACD made a steady series of lower highs. Over the last few weeks, MACD has moved solidly into negative territory with the stock prices forming a massive double top. From here, the $58 level needs to be watched closely as this is the last bastion of key support. If GDW closes below $58, this would represent a major breakdown from a top.

Yet another leading issue, which currently sports a potentially very bearish pattern is CountryWide Credit (CFC). For CountryWide, the $30.50 level is key and any move below that would also be a break-down from a double top. Finally, when we look at financials with highly-leveraged exposure to rising long-term interest rates, Downey Financial (DSL) has done very well over the last few years courtesy of leveraged finance. A double-edged sword, DSL's sharp and sustained decline over the last few weeks, strongly hints that the "deleveraging" process may be underway.

In the end, I suspect that the real culprit behind the decline in mortgage lenders is the prospect of rising long-term rates. Now, some of you may be wondering, has Frank lost his marbles? A RISE in long-term rates? How is that possible in light of Hurricane Katrina and Hurricane Rita? Clearly, the aggregate economic data over the next few months is likely to mean recession or at the very least sharp slow down. Indeed, I agree with the case for a macro-economic slow down - in fact, I agree 100%.

Watch for Consumer Spending to Decline

Higher Energy Costs

Looking ahead, I see four factors strongly suggesting the U.S. Consumer Spending, long the rock and bastion of global economic growth, is facing growing insurmountable headwinds. For starters, we are faced with the disaster in New Orleans, where the near-term effects are sharp increases in unemployment and a tremendous hit to regional spending. Granted � rebuilding will unfold, but this is a longer-term issue that will take lots of time. What's more, one week after Rita, some 78% of gulf natural gas production is still shut down with a significant amount of refining capacity also still off-line. This translates into sharply higher prices for energy this winter. With Americans staring at huge heating bills this winter and the possibility of even higher gasoline prices, the energy headwind alone in coming months could trigger a recession.

New Bankruptcy Law

In addition to higher energy costs, the upcoming Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 will force many debtors to work out their debts instead of walking away from their debts, which will put more pressure on spending. Closely related to the bankruptcy law is a soon to be doubling in credit card minimums, which will stress many consumers to the edge.

Adjustable Rate Mortgage Adjustments

Finally, in the housing sector, large tranches of adjustable rate mortgages are hitting their first resets from October on. For many, this will mean that the monthly mortgage payment could double.

In the aggregate all of these factors argue for a slowing economy.

And What About the Bond Market?

As a result of the issues noted above, were this the typical cycle, the bull case for bonds would be in full bloom. The bond market has historically loved nothing better than a recession.

Yet, this cycle has been the outlier among economic cycles. Nothing about the recovery of the last few years has unfolded as in the past. Name one "recovery" in U.S. history where the total labor force has contracted virtually every month of the so-called "recovery." You can't, because it has never happened before. Even with monumental whitewashing of employment data courtesy of the BLS and its Net Birth/Net Death Model, the aggregate payroll data is way below any recovery of the last 50 years in terms of job creation at every way point along the cycle. Wage data really belies the employment statistics as service sectors wages on a year over year rate of change basis have remained near recession levels for three years. Average workweek still screams slow economy even as we hear forecasts of 4% GDP growth. And speaking of GDP growth, as overstated GDP growth was reported in the last 2 years, bond yields fell at the point of the cycle where they normally would have risen.

In my view, the Achilles Heel of the Bond market is likely to be the Forex Currency market. With the U.S. heavily dependent on vast sums of imported foreign capital, any re-trenchment in access to foreign capital in the months ahead would mean a sharply lower dollar. If I am correct, a lower Dollar will bring about higher, not lower, long-term interest rates even as the economy sinks into recession. It is a strange world we live in, but where foreign capital views the Dollar, it sees the dollar as the standard bearer of highly-leveraged growth.

Sure, the U.S. growth rate has been above that of the rest of the world for the last several years. The U.S., home of corporate capitalism, where job layoffs are a good thing for the stock price, rather than an indictment of poor management, is the home and master of creative finance.

In just the last two years, we have seen credit creation in a single quarter in the U.S. economy take place outside the traditional banking system in a size and scope, which would have taken 10 years to create in decades past. In the U.S., creative finance leading to massive credit creation has truly overtaken and irrevocably altered our financial system. Consider a recent quote from Doug Noland's excellent Credit Bubble Bulletin dated September 16th . In it, he quotes Lehman's Chief administrative officer David Goldfarb at length who stated on a conference call:

"As you know, our balance sheet is an activity driven balance sheet. We use our balance sheet predominantly to warehouse our client activities and our client assets. So when we think about what is the effect on our balance sheet, largely we hedge most of the interest risk we take. We're trying to drive economics based on extracting economics from our client-based activities. And so for the assets that stay on the balance sheet for any length of time, we try to mitigate the risk of interest rate movement. For instance, if you were to look at our balance sheet, most of our assets turn over several times a day. The elements of our balance sheet that don't, for instance whole loans mortgages, which we may originate through our platform, that needs to go through a seasoning period to be securitized, we're hedging interest-rate risk."

In response to hearing this pronouncement, Noland states,

"I should be at the point where I am not surprised by anything. I will admit, however, that I am a little struck by the notion of a Wall Street balance sheet of almost $400 billion turn[ing] over several times a day." Clearly, the brokerage business has evolved profoundly over the past few years, feeding and being well-fed by the booming global leveraged speculating community". (see Prudent Bear)

Consider what we are looking at --- a $400 BILLION Dollar Balance Sheet turning over several times a day � potentially 1 TRILLION dollars in assets a day being turned at just Lehman Brothers. If that is not a staggering thought in the context of the total U.S. economy weighing in at 12 Trillion, I honestly don't know what is. The point here is that when capital views the Dollar, it tends to view the Dollar as growth on steroids.

In a general upswing in the global economy, the U.S. economy, with its creative destruction, outsourcing-globalization and mega-creative finance engine, will outperform in a boom. On the down cycle, debt becomes anathema and capital will seek to avoid leverage and debt. It will therefore seek alternate havens away from the Dollar. In that context, an economy like that of Europe, which is dominated by socialist, quasi-capitalist type thinking creates policies that insure that no boom is ever that big and no bust ever that bad. The trade surplus of the Euro and the huge, intractable welfare states of Germany and France provide enough safety net for relative stability within a climate which shuns debt. Elsewhere, as in Asia, we find high savings, steady growth, low debt and low cost labor, which emerge as the defining characteristics.

Trade Deficit Issues Loom

Thus, if a recession blooms here in the U.S., I would argue that foreign capital will withdraw, seeking the more conservative bastions of finance, which predominate in Europe and Asia, and even increasingly in Emerging Market economies where raw material production is increasingly bolstering state finances. The resulting withdrawal of capital could readily force U.S. rates up, even as overall U.S. consumption declines steadily. To that end, the hallmark of this cycle has been the ever-expanding trade deficit with ASIA, which until now has kept bond prices buoyant and long-term yields under wraps. The "recycle trade" undertaken by Asia Central Banks has monetized U.S. consumption allowing Asian countries to build out a manufacturing base at the expense of American jobs while keeping U.S. interest rates artificially low.

As can be seen in the charts below, as the Trade Gap has widened, consumption has continued to increase with a great deal of the consumption stemming for home equity extraction and the creation of an ever increasing pile of debt. Throughout this process, corporate profits have benefited tremendously as globalization has led to cheaper labor expenses and expanding profit margins.

Dramatic Change in Bond Market Coming

In the coming months, I strongly suspect that bond yields will begin an inexorable advance, which could put serious downside pressure on Financial Stocks and the overall equity market. Where the Bond Market is concerned, there are several ideas, which point to a very dramatic change in the Bond Market in coming weeks.

Trend Change Imminent

To begin with, volatility levels are ultra low - too low, in fact, to be sustainable. In the chart below, I show the Band Spread indicator for the 10-Year Treasury Bond yield and its 200-day trading bands. The Band Spread gauge shows the width of the Bollinger Bands as a function of the moving average. When the spread is very low, as it is right now, it strongly implies a dramatic change dead ahead. Of course, that change could move in either direction, but one implication for the recent lethargic price action in Bonds is to expect an end to the range and the beginning of a more powerfully trending market.

10-Year Treasury Bond Yield: Bollinger Bands

Above: Band Spread on Bonds, at very low levels.
From here, volatility, and risk premiums are likely to begin widen.

Next, if we step back from the short-term market action and look at some longer range charts, some interesting patterns are clearly present. In the chart below, we are looking at 30-Year Treasury Bond yields going all the way back to 1946 and along with them, a 9 MONTH RSI. Note that the RSI moves back and forth between +70 (overbought) and +30 (oversold) with a regular rhythm and that monthly RSI will address changes to the primary trend of a market. In reviewing this chart, the first point that needs to be made is the idea that over the last few years, as bond prices have advanced and long-term interest rates declined, the decline in long-term rates has unfolded against a pattern of declining downside momentum.

30-Year Treasury Bond Yield: 9-Month RSI
1946 to Present

In fact, if you go way back to 1986, we note that the RSI plunged to a multi-decade low at +11.43 as of the month ended 4/25/86 with the 30-Year Bond Yield at 7.59%. That tremendous downside �kick off� begat even lower yields in subsequent years with bottoms in 10/29/93 at 5.97%, 9/30/98 at 4.96%, 10/31/01 at 4/88% and June 20, 2005 at 4.19%.

What's interesting is that as yields declined, the RSI made an elongated pattern of higher, less negative lows with equivalent readings of +13.95 on 10/29/93, +18.90 on 9/30/98, +26.29 on 10/31/01 and +29.17 on 6/30/05. The very strong implication of this sequence is that of a long-term down-trend in yields coming to a conclusion and about to reverse in a secular manner.

Put another way, watch out for rising long-term interest rates as the secular decline rates have now been losing downside momentum for over 5 years.

Treasury Bonds - Overbought Readings
Above 70 on 9-Month RSI:
01/29/49	10/27/50	21 Months
07/31/53	07/29/55	24 Months
02/26/60	11/29/63	45 Months
07/31/70	03/30/73	32 Months
11/29/74	04/28/78	41 Months
11/27/81	05/25/84	30 Months
08/31/84	10/30/87	38 Months
11/27/87	06/30/94	79 Months
12/30/94	11/30/99	59 Months
02/29/00	Present	67 Months
Average Cycle: 34.40 Months

Yet another aspect of the chart above is the tendency to move up and down across the range by RSI. In the table above, I show the longest intervals between overbought readings on the 30 Year Bond – 9 Month RSI going back to 1946. While the average has varied, on balance we have seen overbought readings every 35 to 40 months. Interestingly, the last three cycles have been the three longest with readings of 79 months, 59 months, and with the current cycle at 67 months and counting. Here's the deal: With secular downside momentum for lower yields systematically decreasing over the last 5 years, the odds of this cycle not turning soon have to be rising geometrically at this point in time, as we are currently only 12 months away from matching the longest cycle ever seen.

Bull Signal for Rising Long-Term Yields

In the face of the bullish divergence that has developed on RSI - hinting massively at a secular trend change - the odds are very high that we will see higher, not lower, long-term yields and a move by RSI back up to overbought condition above +70. Turning next to the Weekly chart for 30-Year Bond Yields, I note a very similar pattern. In the top clip I have plotted the 30-Year Bond yield, while on the lower clip I have plotted the Medium Term MACD. Another long term Momentum gauge, note that over the last few years as yields have declined, MACD has made 4 higher, less negative lows while spending the majority of its time below zero.

30-Year Treasury Bond Yield: Medium-Term MACD

Also note that over the last two weeks, MACD has turned up and re-crossed its declining signal line from below. This is a flat-out bull signal for rising long-term yields, and by default, falling bond prices. It is a bullish divergence on a grand scale and has unmistakably strong implications for a major reversal in bond yields to the upside. Looking a bit closer at the near-term weekly chart, we see a classic "W" type bottom in Bond yields with the 30-Year Yield just below its declining 200-day moving average.

In the weeks ahead, any move back above this moving average at 4.55% would be a primary bear signal and would be confirmed by an upside breakout in the months ahead above the May 2004 highs at 5.50%.

30-Year Treasury Bond Yield: 1995-2005

Will long-term rates fall in an upcoming recession as they always do?

In my view, the odds are very high that the anomalistic behavior seen throughout this debt-financed recovery will continue in the downcycle. Namely, whereas yields fell during the period of robust growth and a period when they should have advanced, (trending inversely to the normal cycle) "I believe that in the upcoming period of slow growth, (or negative growth, i.e. stagflation), yields will advance and in so doing, once again run counter to normal widespread cyclical expectation.

In this vein, I believe the answer to the question regarding a catalyst for what appears to be emerging bear markets in both stocks (especially financials) and bonds lies in the currency markets and what should soon be a resumption of the primary bear market in the U.S. Dollar. As capital pulls back from the Dollar, both stocks and bonds will be under-cut, a message resonating loudly right now in the COMEX pits where Gold is pressing 20-year highs".

GST Finance Index -Finance/Mortgage/SubPrime:

Capital One
Accredited Home
Advanta
American Home Mortgage
American Capital
Annaly Mortgage
Anthracite Capital
Anworth Mortgage
Charter Mortgage
Consumer Portfolio
CountryWide
Credit Acceptance
Fidelity National
Friedman Billings
IMPAC
INDYMAC
Metris
MFA Mortgage
MGIC Mortgage
Municipal Mortgage
New Century
Redwood Trust
Providian
Thornuburg Mortage
WFS Financial
Fannie Mae
Freddie Mac
Downey Savings
Golden West

Contact Information

Frank Barbera, CMT | Editor, Gold Stock Technician
PO Box 48072 Los Angeles, CA 90048 | Email