by Kevin Klombies, Senior Analyst

Friday, August 3, 2007

Chart Presentation: TBonds and Yen

Earlier this week we showed that the U.S. equity markets have been trending inversely to the long end of the Treasury market (U.S. 30-year T-Bond futures) and the Japanese yen. This relationship has been very tight this year although that has not always been the case in the past.

We show the S&P 500 Index (SPX) and a combination of the TBonds and the yen (TBonds multiplied by the Japanese yen futures) from 1998.

Through 1998’s Asian crisis the offset to the tumbling equity market was stronger bonds and a strengthening Japanese currency. The bottom for the SPX was made in early October as the bonds times yen product reached a peak.

The basic point is that during times of markets-related stress it is becoming almost normal for the long end of the Treasury market to ramp higher in a hurry. When the yen rises at the same time- and in 1998 it pushed from around .68 to close to .89 between August and October- equities are going to be weaker.

The current situation is shown at bottom right. Notice how the peak for the TBonds times the yen in early March went with the initial lows for the SPX and then as the product faded lower the SPX began to recover. The same thing happened through July.

What we found interesting here is the way the TBonds times yen combination provided some amount of advance warning that an equity markets problem was looming. The chart shows that the combination made three ‘higher lows’ through February before the SPX began to crack. The combination made another three ‘higher lows’ between mid-June and early July which, in hind sight of course, was the markets’ way of telling us that the problem was brewing.

The last point would be that in mid-March the SPX appeared to breaking to new lows early in the session before reversing back to the upside. Notice that the TBonds times yen combination was trading well below the early March highs which suggested that the trend for equities back to positive. In the current situation it is possible that the SPX has already made its corrective bottom but if history repeats it will take lower bond prices and a weaker yen to confirm that the worst has already passed.



Equity/Bond Markets

The chart compares the Fed funds futures with the ratio of lumber futures to crude oil futures.

We really like this chart because it does a very nice job of showing what has gone on over the past year or so. The argument is that lumber prices tend to rise after short-term yields turn lower while rising crude oil prices tend to push yields higher. The ratio of lumber to crude oil should bottom at the peak for the Fed funds rate and resolve higher as the Fed cuts interest rates.

The chart shows how the markets anticipated a cut in interest rates between August and January only to remove all of that anticipation between January and July of this year. As the dust settled the Fed funds rate is still 5.25% and the lumber/crude oil ratio is back to the range set in the summer of last year.

Below we show charts of the ratio between crude oil and the TBonds futures along with the ratio between the stock prices of Coca Cola (KO) and Schlumberger (SLB).

The chart below shows the time period from late 1989 into 1991. The idea is that the peak for crude oil should go with the bottom for the KO/SLB ratio. Fair enough.

The problem this time around is that while the KO/SLB ratio is now back to the same level that marked the lows in 1990 (just below .6:1) we have had to go through a second ‘top’ for oil prices. Similar to the chart at top right the markets have been forced to ‘re-set’ all of the relative prices after the initial rally into January reversed back in favor of stronger oil prices.