by Kevin Klombies, Senior Analyst

Friday, April 25, 2008

Chart Presentation: Cycling

A week or two ago the markets expected the Fed to cut the funds rate by something between 25 and 50 basis points following the April 30th FOMC meeting. Earlier this week the Fed funds futures had adjusted to show an almost certain 25 basis point cut while through the end of trading yesterday the odds had declined to 82% with an 18% chance of no rate change. As well the markets are now anticipating that the Fed funds rate will hold at 2% through the June and August meetings. In other words… we have reached what appears to be the bottom for short-term U.S. interest rates.

April 25 (Bloomberg) — The dollar may extend its rally against the euro as traders increase speculation that the Federal Reserve will stop cutting interest rates.

The point is that once U.S. short-term interest rates find a bottom the pressure on the dollar should abate and given that a very large proportion of the strength in commodity prices has been based off of dollar weakness this puts the commodity sector at serious risk.

Below we show a comparison of, from bottom to top, AMR, oil refiner Valero (VLO), Barrick Gold (ABX), and Canadian natural gas producer Duvernay (DDV on Toronto).

We have shown a version of this chart on a few occasions in the past. The argument was that the markets continue to cycle or rotate- rather frantically- from theme to theme. This creates tremendous price runs for those early to the party and nice profits for those who can tell the difference between a cycle and a long-term trend.

In late 2006 AMR’s stock price doubled from 20 to around 40 and as it reached a peak the markets shifted into something of a refined products theme which led to a nice run for Valero. As VLO reached a peak the markets rotated into the golds and by early 2008 Barrick’s stock price had come close to doubling. From there the theme shifted to natural gas so, as one might expect, Duvernay’s stock price went for a ride until it had doubled from 25 to around 50. Strangely ‘on cue’ the U.S. dollar comes back to life just as the CRB Index appears poised to move to new highs leading to a rather sharp crack in the commodity theme.

Given that the markets are undoubtedly going to roll into something new our challenge is to identify the next theme as quickly as possible!


Equity/Bond Markets

To quickly finish off the page 1 argument the markets have cycled through four different themes since the autumn of 2006. To truly start something new the dominant theme has to end so in a perfect world the energy and grains trend has finally reached a peak.

If we were to guess- and we are inclined to do so today- as to the next theme we would submit that the chart of Intel today appears quite similar to AMR in the autumn of 2006. We might also throw a few telecom names into the mix including Deutsche Tel (DT) which is likely to do somewhat better on euro weakness.

There are three markets hovering around the ‘137’ range. The Japanese 10-year (JGB) bond futures closed yesterday at 136.85 to give a yield of close to 1.5%. The S&P 500 Index futures are close to 1385 while the Nikkei 225 Index futures ended at 13,720.

The Nikkei tends to do well when long-term interest rates are rising so in most cases the Nikkei will rise as the price of the JGBs move lower. The Nikkei also tends to outperform the SPX when yields are rising.

The chart below right shows the ratio of the Nikkei to the SPX and the ratio of the Nikkei to the JGBs. A rise above 10:1 by the Nikkei/SPX ratio would be positive while a rise above 100:1 by the Nikkei/JGB ratio would also be helpful.

Quickly… the trend for gold is similar to the trend for the spread between the TBond futures and the U.S. Dollar Index. The main point here is that the trend up from the end of the second quarter of last year is getting a good test but it most likely has not been broken. That may have to wait until after the Fed meeting next Wednesday although if the dollar continues to rise while the TBonds decline this could turn into a rout of the commodities markets.