A Flat Yield Curve, Two Views

I heard Art Laffer, of the Laffer Curve, expound on Rush Limbaugh this morning that the economy is going great, that Bush is to be admired for keeping his hands off the economy, like Clinton and Reagan. Greenspan has done a great job and the economy is healthy and there is no inflation. The bond market with its flat yield curve is no worry. Since there is no inflation for as far as investors can see, a flat curve is a healthy sign. And the yield at the long end is providing a positive yield.

On the other hand, and with economists isn’t there always “another hand”, it pays to read Bill Cara Wednesday as he wrote about the yield curve.

…due to the size of the bond market, neither the Treasury nor the Fed can manage the long-term bond yield as well as they can and do the short-term rates. In fact, in just five years, the bond market has grown so huge, and the percentage of U.S. Treasury debt in the control of foreign traders (now over 50 pct versus one-third in 2000) that I believe U.S. monetary policy is out of control, i.e., it can no longer be used as an effective control mechanism.So, with respect to the yield curve, I now believe that international financial and capital markets are in control.

What does that imply? For one, the occupant of the White House is no longer the master of his domain. From this point forward, whenever financial and capital market risks, and opportunities for creating wealth, warrant the re-investment of foreign capital into their own domestic economies, foreigners will sell their holdings of U.S. debt. And the moment that begins to happen, the U.S. bond market will fall, and rates will rise.

[…]

…the flatter the curve, the more attractive bonds will be relative to equities. The higher the level of rates, the less attractive bonds become, but the more risky equities become (average PE multiples will fall). In both cases, gold will out-perform.

So we have lost control of monetary policy to foreigners, who are currently finding bonds more attractive than stocks and if a better opportunity comes along they sell bonds, leading to higher interest rates which are not good for stocks. Bill Cara like Mover Mike thinks Gold and gold mining stocks will benefit.

Update: I just received my Weekly Chart of the Day and here is a chart that supports the position that Cara and I make:

Art Laffer gold Mover Mike

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