Financial Watch

Treasury yields on the U.S. ten year note surpassed 5% for the first time since 2001 this past week. This marks the first time in years when investors are able to obtain a higher yield from the bond markets than can be obtained through the stock markets. Although 5% is still a comparatively low return in comparison to the strong returns that can be realized through equity investments, it marks the point where U.S. treasuries offer a sufficient return to attract investors from the stock markets. In recent months, U.S. stock markets have rallied nicely from their lows following Hurricane Katrina last fall. Fears of higher commodity prices and rising interest rates have caused a modest pullback. It appears the pullback will be short lived. Economic growth is strong at the moment and inflation is under control.

The reemergence of spread between short-term treasuries and those of longer durations indicates a fundamental shift in the bond markets. Over the past year, the flat yield curve has been supported by Asian central banks that have intervened in the currency markets through the purchase of U.S. treasuries. As a result of foreign interventions long-term treasuries have traded at yields outside of their fundamentals. At the moment it is difficult to determine the reasons behind a changing yield curve. Our trade deficit of $800 billion this year will well surpass our nation’s budget deficit indicating foreigners will more than meet our government’s borrowing needs through treasury purchases. At Financial Watch we believe the steeper yield curve is being caused by China’s temporary slowdown in purchasing U.S. treasuries. Trade issues will be at the forefront when President Bush meets with China’s president this month. At the moment we believe China is allowing market forces to exert greater impact on its currency leading up to the important meeting. At the same time treasury yields are rising we are also seeing a more rapid rise in the value of the Chinese yuan against the U.S. dollar.

A steeper yield curve will have several impacts on the U.S. economy. First, Financial Watch will reinforce what we have been saying for the past year. The housing boom is over. Fixed mortgage rates are heading to 7% and have moved up about 25 basis points in the past couple weeks. Year over year, in a couple months it will cost 30% more to take out the same mortgage that could be taken out a year earlier. Incomes are up only 3.5% from a year ago. Enough said! The second impact is that some equity investors will seek to diversify into safer bond investments. In the past two and a half years stock market returns have averaged about 5.5% or 7% with dividends. Ever since the bubble burst investors have believed stock market returns in the future will be in the single digits forever. This misconception will continue until we see consistent double-digit gains. No one seems to notice corporate profits are growing at a consistent 12% clip. Financial Watch believes we will see the Dow above 20,000 this decade. In fact, it would not surprise us if it approached 25,000 this decade. In all likelihood, modest stock market returns this year will beat what can be earned in the bond markets. On a final note, our lofty predictions for the stock markets this decade do not mean we expect astronomical returns this year. A new stock market bubble is not upon us just yet.