by Kevin Klombies, Senior Analyst

Friday, December 7, 2007

Chart Presentation: Ratios

The chart at right compares 10-year U.S. Treasury yields with the ratio between the Japanese and U.S. equity markets. The Nikkei tends to outperform the S&P 500 Index when the base trend for long-term interest rates is rising.

The chart below right shows the ratio between Japan’s Mitsubishi UFJ (MTU) and the Nikkei 225 Index. The ratio declines when there is downward pressure on long-term yields and rises when yields are moving upwards. The sharp recovery in the ratio suggests that the markets are at least willing to consider the possibility that the worst is now over for the subprime crisis.

In general the Japanese equity market tends to do better when bond prices are declining so the trend for the Nikkei divided by 10-year Japanese (JGB) bond futures tends to reflect the strength of the broad cyclical theme. A number of sectors swing with this ratio including the biotechs. Below we compare the Nikkei 225 Index/JGB ratio with the biotech etf (BBH). The BBH was hit this week by the decline in the share price of Genentech (DNA) following negative FDA news. Both the BBH and the ratio last turned positive back in mid-2005.




Equity/Bond Markets

The chart at right shows the ratio between gold and copper futures prices. The ratio rises when there is downward pressure on interest rates and falls when there is upward pressure. The rather erratic trend for the ratio over the past two years likely has something to do with the conflicting trends between short and long-term yields. On page 1 we showed that the base trend for long-term Treasury yields turned lower in early 2006 in the midst of rising U.S. short-term interest rates, just after the start of rising European yields, and right about the time Japan began to move rates up from close to 0%.

Through 2006 the ratio fell and then rose on commodity price weakness and then in 2007 it fell and then rose on weakness in the financial sector. Given that the ratio started both 2006 and 2007 at a peak we could make a loose case that the ratio would remain near the highs with gold outperforming copper into early 2008.

The basic argument for higher bond prices comes from continued turmoil and crisis in the credit markets. The idea has been that the lows for Merrill Lynch (MER) should be reached at the peak for long-term Treasury prices. To date MER has held the November lows while the TBonds have remained below the rather critical 119- 120 level.

We are starting to see better action in some of the more cyclical sectors including the semiconductors. The stock price of Micron (MU), for example, trends very closely with that of Mitsubishi UFJ (MTU) and both do better when bond prices are falling. The chart below shows that MU has been trending inversely to the TBonds so as bond prices decline we see tentative indications of strength in the tech and telecom sectors. If we can just get through today’s U.S. employment report and the digestion of the subprime mortgage plan without too much bond price strength we will have to rather seriously consider a positive view on MU.