by Kevin Klombies, Senior Analyst

Friday, August 8, 2008

Chart Presentation: History Repeating

In yesterday’s issue we focused on two ideas. The first idea was that the equity markets had started to shift back towards the commodity cyclical sectors in a manner that suggested that there was an expectation that the dollar would weaken to re-energize the commodity-based trend. The second idea was that from a number of perspectives the U.S. dollar had reached levels very similar to those of August, 1995 which just happened to be the last time the U.S. Treasury intervened on behalf of the dollar. Our thought was that if the Treasury were so inclined they might step in to run the dollar early next week.

We are going to return today to an argument that we have made in these pages on a number of occasions in the past. We start with a chart comparison below of the U.S. 30-year T-Bond futures and the product ofcrude oil futuresmultiplied by natural gas futures from mid-1999 through 2001.

The chart shows that the TBonds began to trend higher in price in January of 2000 while energy prices (oil times gas) did not peak until January of 2001. Along the way the tech and telecom sectors (Nasdaq) peaked and turned lower.

The point is that if history were to repeat then energy prices should be very strong for one year after bond prices began to rise but that during the intervening period one or more major and speculative sectors should break to the down side.

The chart below shows the same comparison from mid-2006 forward. The TBonds pivoted to the upside in July of 2007 and, true to form, energy prices accelerated higher for a full year before reaching a cycle peak in July of 2008. Along the way any number of cyclical markets began to tumble although we have tended to use something like the Shanghai Composite Index in the current cycle as a surrogate for the Nasdaq in 2000.

The last point that we wish to make would be that the bond marketdid not reach a peak until late in 2001. More specifically the bond market continued to rise in price until the price gains from energy prices through 2000 were finally erased. The argument would then be that bond prices should remain generally ‘higher’ until the product of crude oil times natural gas falls all the way back below ‘500’. Something like $7 natural gas and $70 crude oil, $6 gas and $80 crude oil, etc.



Equity/Bond Markets

The page 1 argument was that long-term Treasury prices should continue to rise until energy prices have declined back to mid-2007 levels. In general this should mean natural gas prices back to around 7 with crude oil in the vicinity of 70. We suspect that these numbers are fairly reasonable.

The chart below compares the U.S. 30-year T-Bond futures with two moving average lines for… the sum of 3-month eurodollar futures prices and the Fed funds target rate.

We use the sum of eurodollars plus the Fed funds rate because in a perfect world it should hold very close to or just below ‘100’. The Fed funds rate is a one-day or overnight interest rate while the price of 3-month eurodollars represents the 3-month yield.

If 3-month Treasury yields are, say, 3% then eurodollar prices would be around 97. If the Fed funds rate was also 3% then the sum of the two would equal 100. Since 3-month yields are typically higher than one-day yields the sum tends to gravitate towards the 99.80- 99.90 region.

Now… we use two moving averages lines instead of daily prices to smooth out the trend. The faster of the two moving averages (the blue-green line) is the 50-day e.m.a.

In any event… when we show this chart comparison the argument is that when the moving average lines rise above ‘100’ the bond market is at a price peak. The last time this occurred was this past March when the TBonds were pushing above 121.

The chart has gone from indicating a price peak for bonds in March to what appears to be a fairly major price bottom in August. The sum of the Fed funds rate and eurodollars as shown by the moving average lines is now at a level that has not been seen since late 1999.

The argument, by the way, is that one of the two- the Fed funds rate or short-termdebt prices- is ‘out of whack’. Either the Fed funds rate is much too low OR debt prices have to rise.

At bottom we show copper futures and the spread or price difference between 30-year and 10-year Treasury futures.

In general the trend for copper futures prices moves inversely to the trend for the spread. Put another way when copper prices are strong and rising this usually goes with falling bond prices and a declining spread. Why? Because the longer the term of a bond the faster its price will move.

When copper prices are falling- as has been the case recently- the spread should rise and this is typically accomplished through stronger bond prices.

The point? We showed on page 1 that long-term Treasury prices should resolve higher until energy prices are substantially lower than current levels. We then argued at top right that the divergence between the Fed funds rate and 3-month eurodollar futures is at levels that in late 1999 marked the start of a very strong bond price rally. We then went on to show at bottom right that one of the drivers behind a rising bond price trend should come from weakness in base metals prices. If we are wrong copper prices are headed to new highs above 4.00. If we are right then copper prices will continue to decline back towards or below 2.00.