by Kevin Klombies, Senior Analyst,

The slope of the yield curve tends to provide incentive for money to move away from risk (especially when long-term yields are lower than short-term yields) and back towards risk (when long-term yields are substantially higher than short-term yields. At present fixed income traders still consider anything longer than about 10 days as ‘high risk’ but in due course the steeply sloped curve (chart below) will convince traders to stretch somewhat in search of larger returns.

The chart at right compares, from bottom to top, the ratio between the share price of Wal Mart (WMT) and the S&P 500 Index (SPX), 1-month LIBOR futures, 2-year T-Note futures, 5-year T-Note futures, and 30-year T-Bond futures.

In the face of daily declines in the price of the U.S. 30-year T-Bond futures we have remained steadfastly positive on the bond market. Why? Two reasons come to mind but only one of them is flattering enough to mention here. Our view is that there is a trillion dollars plus worth of leverage due to hit the markets in the weeks to come and that this will serve to push money ‘out’ from the safety of cash. The WMT/SPX ratio serves as our baseline for slowing commodity and Asian growth and it has been rising since the autumn of 2007. From there we can see 1-month LIBOR futures prices rising- and making new highs finally last week- with longer duration Treasuries lagging behind.

In time money will move from over night to 1-month and then out to 2-years, 5-years, and then into 30-years as financial asset prices outperform real asset prices.



Equity/Bond Markets

In a recent issue we revisited the idea that the commodity markets follow the bond market by roughly two years. The argument was that major peaks for long-term Treasury prices tend to precede tops for the commodity market by two years while bond market bottoms lead the lows for commodity prices by a similar time span.

The argument is interesting in a number of respects. It suggested- to our rather obvious chagrin- that the peak for commodity prices should have been reached no later than the spring of 2006. Our subsequent argument was that the collapse in commodity prices this year was largely due to the fact that the trend has been negative for more than two years.

In any event the last major bottom for the bond market was reached in mid-2007 so the idea is that commodity prices will remain flat to lower through the second quarter of next year. We use the term ‘flat to lower’ simply because trend line support next year for the CRB Index would be somewhere between 230 and 240 compared to last week’s close around 268. There is still down side in the commodity markets but not anywhere near as much as there was a few months ago.

This is the time in the cycle when financial asset prices should be rising relative to real asset prices. In other words the ratio between the CRB Index and S&P 500 Index should be moving lower. The problem at present is that financial asset prices IN GENERAL are still not rising. Equities were better last week but the long end of the Treasury market is still weaker which shows up in the upward spike by 30-year yields on the chart at right.

Our point is that we ended the week with the CRB/SPX ratio on the verge of making new lows even as 30-year yields and the ratio of the oils to the broad market spiked higher. If these are the three key relationships that should lead the equity markets back into a sustainable recovery then we were no better than one out of three last week.

Our view is that in time 30-year yields will move below 3.90%, the ratio between the Amex Oil Index and S&P 500 Index will move from just below 1:1 down to roughly .5:1, and the CRB/SPX ratio will fall from around .28:1 down to closer to .2:1.

Below right is a chart comparison that we have included in the IMRA on a couple of occasions in the past. We find it interesting enough to run once again even though we are unsure of whether it is of going to be of any use in the future.

The chart compares the S&P 500 Index (SPX) with the spread or price difference between Brent crude oil futures (last seen at 65.60) and the stock price of Canada’s Canadian Natural Resources (CNQ on Toronto and also on New York- last seen at 60.82). CNQ is one of Canada’s major oil and gas producers with substantial assets in the Alberta oil sands.

The argument is that the last two peaks for the SPX (in 2006 and 2007) were reached right around the time the Brent minus CNQ spread rose up through +5. First, however, the spread had to fall well below +5. It remained under this level for roughly six months into 2006 and a full year into the autumn of 2007. Quickly… the idea is that as long as CNQ is trading close to or above the price of Brent crude futures then the equity markets are in a positive trend. When oil prices strengthen to the point where they move more than 5 points above the share price of CNQ then in both 2006 and 2007 this marked the peak for the SPX and the start of some form of broad equity markets correction.