by Kevin Klombies, Senior Analyst

Monday, December 3, 2007

Chart Presentation: Gold/Copper

The markets continue to forecast a Fed rate cut following the December 11th meeting. As of the end of last week the odds of a 25 basis point cut to 4.25% were only slightly higher than a 50 basis point reduction to 4.0%. Coupled with declining crude oil prices the U.S. equity markets ended the week on a positive note.

We tend to show a rather wide and disparate selection of views in the IMRA and at times these views are conflicting or even completely contradictory. We rationalize this because we suspect that at times- perhaps most of the time- the sum total of all investment decisions and opinions that makes up ‘the market’ is as confused as we often are. This is especially true at the points where trends change.

Recently we showed the ratio of gold to copper futures and pointed out that copper prices had started to outperform gold. Since relative prices can do almost anything on any given day we tucked the chart and its ramifications onto the back burner to let it simmer for a while longer. By the end of last week, however, this key potential trend change had become significant enough for us to haul it out once again for examination.

The basic point is that gold rises relative to copper when there is downward pressure on interest rates- usually short-term interest rates. When the cyclical trend is strong and rising copper tends to outperform gold so the direction of the gold/copper ratio gives us a sense of whether the cyclical trend is faltering or strengthening.

At top right we show the gold/copper futures ratio. Of interest is the way the ratio went from top to bottom and back to the top in 2006 through the broad decline in commodity prices and then from top to bottom and back to top during the negative trend for the financials this year.

The chart at bottom right compares Bear Stearns (BSC) with the CRB Index. Notice that the bottom for the CRB Index was reached this past January at the peak for the gold/copper ratio. If the ratio is making a third peak this month then it is possible- perhaps even likely- that the financials have just made a bottom in a manner similar to the commodity sector last January. Unless a third major sector joins the party this would argue for better financial stock prices and lower commodity prices into 2008. More on this on page 5.



Equity/Bond Markets

We have been focusing rather intensely on Japan’s Mitsubishi UFJ (MTU) of late because it fits in with our macro view that one of these days (years, decades) Japan is going to escape from deflation. We have argued in the past that the ‘one thing’ that has to happen to show that this is the case is rising long-term Japanese interest rates. In particular we have pointed out that 10-year Japanese yields (currently 1.46%) have to move above 2.0%. It does Japan’s banks little good to have the Bank of Japan raising short-term interest rates while long-term yields are falling- a point made quite clearly by the 50% ‘hair cut’ in MTU’s share price since the spring of 2006.

In general the Nikkei outperforms the S&P 500 Index (SPX) when long-term yields are rising and underperforms when yields are falling. Consider the conclusions that one might have come to earlier this year is one had believed that this ratio was ‘right’ even as 10-year Treasury yields pushed back to 5.2%. The ratio argued that yields were going lower well before the subprime crisis surfaced to show us WHY yields had to decline.

When long-term yields are falling the Nikkei underperforms the SPX and MTU underperforms the Nikkei so getting the direction of long-term interest rates correct becomes rather important. On the other hand one could easily argue that this works better in reverse- that relative strength in the MTU/Nikkei ratio as well as the Nikkei/SPX ratio will tell us which way yields are trending.

The bottom line is that MTU is a rather high-beta play on the direction of yields so to be positive on this stock we have to also believe that the bond market is ready to ‘split’ with falling short-term yields going with rising long-term yields.

This argument is not specific to the bond market because the same trend is evident in the European currencies. The Swiss franc, for example, turned upwards in early 2006 as biotechs like Genentech (DNA) turned lower. A better dollar and rising long-term interest rates would go a long way towards swinging the trend away from commodities and back towards the Nikkei and biotech.