by Kevin Klombies, Senior Analyst

Tuesday, July 31, 2007

Chart Presentation: TBonds

In yesterday’s issue we mentioned in passing that while we were only looking for a rally back towards the 110- 111 for the U.S. 30-year T-Bond futures we could justify a much larger price recovery all the way up to the 120- 125 range. To explain where these numbers came from we have included at right a comparison between the TBond futures and the sum of the Fed funds rate and 3-month eurodollar futures prices.

The sum of the Fed funds rate (currently 5.25%) and 3-month eurodollar futures (94.6775) currently adds up to 99.9275. In other words it is less than 100 which is normal because in almost all cases the yield on overnight or 1-day money is less than the yield for a 3-month term.

The sum is shown using two moving average lines- a 50-day and a 100-day e.m.a. The idea is that in rare cases the yield curve will invert until 3-month yields are below the overnight funds rate and when this happens the sum of the funds rate and 3-month eurodollar futures will rise above 100. If the sum rises far enough above 100 or remains above this level for some length of time the two moving average lines will also move above 100.

On occasion- perhaps once every year or three- the moving average lines rose above 100 and when this happens long-term bond prices tend to be at or near a peak. The top for the TBonds in early 1996 and the bond price spike in 1998 during the Asian crisis are two examples. The most obvious case was early 2001 at the start of the ‘tech wreck’ when the moving average lines rose through 100 on the way to 100.40.

The moving average lines have held below 100 since bond prices topped out in mid-2003 so more than four years have elapsed since the last ‘sell’ signal generated by this chart.

The recent subprime mortgage problems have resulted in a broad rise in U.S. Treasury prices. To date the pressures have not been great enough to push 3-month eurodollar yields below the funds rate but it is entirely possible that this will happen either later this summer or into the seasonally bleak autumn. The U.S. 30-year T-Bond futures have been trending higher within a reasonably well defined channel so a rally into the top portion of the channel between 120 and 125 would be consistent with past examples.


Equity/Bond Markets

Certain details and features of the current market are remarkably similar to ten years ago so we return today to the comparison between 2006- 2007 and 1996- 1997.

We have included a chart of, from top to bottom, the sum of copper and gold futures (copper in cents and gold in dollars), the stock price of Newmont Mining (NEM), the Airline Index (XAL), and the CBOE Volatility Index (VIX).

While Newmont produces copper it is primarily a gold miner. The stock made an cycle peak in May of 1996 before trending lower through 1998. The top for NEM in 1996 occurred at the end of the rally for metals prices.

In May of 2006 the stock price of NEM reached another cycle peak. In fact, the highs for NEM in 2006 were virtually identical to the top back in 1996. Similar to 1996 the end of the rally for NEM occurred at the peak for the sum of copper and gold futures.

Recently the markets have become more volatile and most believe that higher volatility goes with lower equity prices. Usually this is true but we will argue that it is not a given.

Our view is that low volatility goes with strong metals prices. Not strong metals prices exactly but rather the kind of trend that includes strong metals prices.

Consider that one of the key features of a bullish metals trend is the market’s willingness to push capital into global nooks and crannies. A decade or so ago money was pouring into mining projects in South America, Africa, and perhaps especially Indonesia (remember Bre-X?). Two years later capital was moving so relentlessly out of Asia, Russia, and even Brazil that it created a financial crisis.

The sharp rise in the VIX this year is consistent with the pick up in volatility in 1997 and in both cases this occurred well after the peak in the stock price of Newmont.

We mention this because one of the strongest periods in recent history for the autos and airlines theme extended from 1997 into 1998. Rising volatility is consistent with falling metals prices and a weaker mining sector but is not always a negative for the broad U.S. equity market. We only have to look back to the doubling in value of the Airline Index from 1997 into 1998 to see that volatility is not necessarily something to fear.

We will return to this argument on the next page but since we are also going to work the stock price of Wal Mart (WMT) into the equation we thought we would show a short-term perspective at bottom.

Aside from the rather obvious fact that WMT is not rising and the Shanghai SE Composite Index made new highs on Monday (chart on page 6) we wanted to focus on the two moving average lines on the chart. The red line is the 200-day e.m.a. while the blue-green line is the 50-day e.m.a. Typically when the blue-green line is above the red line that is bullish and when it crosses to the down side that is bearish.

Notice that each time WMT has broken below its 200-day e.m.a. this year (which pulls the 50-day e.m.a. lower) it has snapped back above this line in short order. In other words the stock is trying to remain positive in a rising equity markets trend. Last week’s stock market rout has take WMT below the moving average line once again so if history repeats it should find some way to push back into the 48’s.