by Kevin Klombies, Senior Analyst

Wednesday, June 25, 2008

Chart Presentation: 2-Year Lag

The Fed funds futures argue that there is a 90% chance of no change in the funds rate today with a 10% chance that the target rate will be raised to 2.25%. In other words we would expect the Fed to hold the funds rate at 2.0%.

The market expects that the Fed will begin the process of raising interest rates in September. Our view is that by next month one of two sectors- the banks or the commodity markets- will start to weaken and by August the other will ramp higher as an offset. A renewed banking system crisis or flat-out commodity markets weakness will keep the Fed on hold until well into next year.

Over the years we have often run chart comparisons based on a 2-year lag between changes in interest rates or bond prices and the commodity markets. The idea was that a major shift in the direction of interest rates today will impact the trend for commodity prices in about two years.

We are going to present a ‘spin’ on this argument today using the share price of General Electric (GE). We were originally going to use the share price of Starbucks (SBUX) but we are little more interested in GE these days.

The charts below show the sum of 3-month and 10-year U.S. Treasury yields along with GE. The charts have been shifted or offset by two years so that the low point for yields in the autumn of 1998 lines up with the peak for GE in the autumn of 2000.

The idea is that when interest rates reach a peak it will lead to a bottom for cyclical asset prices about two years later and when interest rates reach a bottom we would expect to see a top for cyclical asset prices roughly two years into the future.

Interest rates peaked through 2000 before turning lower near the end of the year while GE’s share price declined to a bottom in 2002 before swinging into a recovery.

The first peak for yields was reached around the middle of 2006 which helps explain why GE has been under such intense pressure through the first half of 2008. The trend will not truly turn positive for GE, however, until some time around the middle of 2009.



Equity/Bond Markets

We are fascinated by shiny baubles and strange chart comparisons so we wanted to run the Merrill Lynch- heating oil chart one more time.

On page 1 we commented in passing that our expectation is that the Fed will NOT raise interest rates this year. The reason that they will hold the line will become apparent through the next quarter and will be based on weakness in either the financial or the commodity sector.

In July of 2006 the commodity markets turned lower while the financials swung upwards and in 2007 the financials turned lower in July while the commodity markets strengthened.

The chart shows that on a number of occasions over the past two years heating oil futures times MER equaled ‘150’. If the second half of this year leads to falling energy prices then we would expect to see MER on the rise while new highs for energy prices would go with new lows for MER.

Below right is a comparison between the CRB Index and the ratio between the pharma etf (PPH) and Caterpillar (CAT).

We have argued from time to time that the equity markets go down with CAT and up with the PPH. By this we mean that while the PPH tends to turn lower ahead of CAT the broad market will tend to buckle once CAT’s stock price begins to weaken. The leading edge of the next bull trend begins when the pharma sector turns higher.

In any event the PPH/CAT moved higher in the second half of both 2006 and 2007 and after yesterday it appears that 2008 will offer more of the same. The ratio reached a peak in January of 2007 and again in January of 2008 so if history repeats the pharma sector should outperform cyclicals such as CAT into January of 2009.

The SPX tends to bottom around the time that the crude oil/30-year T-Bond ratio reaches a peak. The ratio has been moving sideways through much of June as minor strength in oil prices is offset by rising bond prices.