by Kevin Klombies, Senior Analyst,

The greater the volatility in the markets the more likely we are to show very long-term relationships. At time of writing a bail out bill has been proposed but not voted on, the U.S. equity futures and dollar are showing small gains, while energy, base metal, and agriculture futures are trading lower. All of that could change, however, by the time trading opens in North America on Monday.

Below we feature a chart of the sum of 3-month and 10-year U.S. Treasury yields- scaled upside down. We have flipped the chart over because the relationship that we wish to show is based on ‘price’ instead of ‘yield’. In other words when the line on the chart is rising it means that prices are increasing as the combination of short and long-term yields moves lower.

We also are featuring a chart of the CRB Index.

The two charts have been shifted or offset by 2 years so that 1997 for upside down yields lines up with 1999 for commodity prices.

The argument is and has been that the trend for bond prices today shows up in the trend for commodity prices two years into the future. In other words the lag between trend changes for interest rates and the resultant impact on raw materials prices is roughly two years.

Very quickly… when the Fed cuts the funds rate it initiates a chain reaction through the markets. The yield curve steepens as short-term yields decline relative to long-term yields. Investors are incented by the market to push money into longer-dated investments in order to get a higher yield. Over time 1-year and then 2-year and eventually 10-year and even 30-year yields move lower. As yields decline money begins to push into interest rates-sensitive equities and then into more cyclical sectors. Business starts to pick up, profits expand, capital spending increases, and eventually raw materials prices rise. The argument has been that the CRB Index lags Treasury prices by very close to 2 years.

The problem- and it was a significant one- was that we used this argument through 2005 and 2006. It was our expectation that the CRB Index had peaked during the spring of 2006 and was heading lower. We mention this because over the past few weeks we have focused from time to time on the share price of Coca Cola and/or the KO/SPX ratio. The argument was that it in a most peculiar way we can still make the case that the commodity cycle actually made a peak back in 2006 and, if this proves to be the case, then the CRB Index is some distance ‘above trend’ at the present time.



Equity/Bond Markets

The chart below compares the ratio between Coca Cola (KO) and the S&P 500 Index (SPX) with crude oil futures.

The page 1 argument was that based on the relationship to Treasury yields and prices the CRB Index ‘should’ have peaked back in early 2006. Obviously it didn’t. However… from an intermarket point of view the peak for the CRB Index ‘should’ have gone with the bottom for the KO/SPX ratio and it turned higher in early 2006. The issue at present is whether the major trend swung back to commodities- as so many believe- or whether the 9-month consolidation in the KO/SPX is merely a pause within a rising trend.

From our perspective this is very important. If the KO/SPX ratio pushes to new highs then commodity prices are trading so far above trend that the oil price decline of late 1985 into 1986 becomes somewhat relevant. It opens up the potential for an unwinding of commodities as an asset class. However… to date the KO/SPX ratio remains well below the series of peaks set between January and September of this year and we suspect that this ratio will only make new highs if crude oil prices are set to break below 90.

Below we show a comparison anchored at the bottom by the biotech etf (BBH). The chart shows the BBH, AMR, refiner Valero (VLO), gold miner Barrick (ABX), and finally natural gas producer Chesapeake (CHK).

The ongoing argument has been that the ratio of crude oil to the U.S. 30-year T-Bond futures peaked in both July of 2006 and July of 2007 (as well as October of 1990). In 2006 the biotechs led to the upside followed by the airlines in September. By the end of the year AMR and the BBH had peaked as the markets rolled into the refiners (VLO). Six months later the trend shifted to the gold miners (ABX) and then six months after that the trend returned to the energy theme with strength in the natural gas and coal producers.

The point? The biotechs have been strong through the third quarter but the airlines are still somewhat ‘channel top’. We would like to see AMR push above the recent highs just above 13 but suspect once again that this will only happen if crude oil futures prices are set to decline below 90.