by Kevin Klombies, Senior Analyst

Thursday, November 29, 2007

Chart Presentation: The 2-Year Lag

The largest rallies for energy prices over the last number of months have come on Thursdays in much the same way that prices have tended to decline on Tuesdays. Withcrude oil futuresprices now back to the rising trend line that began in August the trend should get a good test today.

We are returning to a relationship that we have shown on two previous occasions in the IMRA. We throw a wide and varied array of views against the proverbial wall but when we place more than a passing interest on a theme or a thesis we tend to beat it to death until it either works or convinces us otherwise.

At right we show the CRB Index from 2006 to the present day while below right we show a comparison between 3-month euribor futures and 3-month eurodollar futures starting two years early in 2004. The charts have been shifted or offset so that commodity prices in 2007 are compared with short-term debt prices in 2005.

One of our recurring arguments over the years has been that the trend forcommodity priceslags changes in interest rates by very close to two years. Over time we have focused on the long end of the Treasury market or a combination of short and longer-term Treasury yields to make our point.

The creation of the Euro-zone may have changed the relationship, however, because instead of a number of smallercentral banksmoving interest rates higher and lower at various times we now have one major central bank- the ECB- setting policy.

The argument was that the CRB Index should reach a cycle peak about two years after U.S. short-terminterest ratesbegan to rise so the first top in the CRB Index in the spring of 2006 made perfect sense give that 3-month eurodollar futures prices began to decline in the spring of 2004.

Our rationalization for a second top late in 2007 is that European interest rates remained at a bottom until late in 2005.

Our thought is that the most significant and intense downward pressure on commodity prices should run from this quarter through into the middle of next year because two years previous both the U.S. and Europe were pushing interest rates higher.



Equity/Bond Markets

The chart at right shows the ratio between gold and copper futures prices. The ratio tends to rise when there is downward pressure on interest rates and decline during periods of rising pressure on yields.

Why are we showing this today? Mostly because we noticed that through much of yesterday’strading sessiongold was lower and copper was higher and when this happens it tends to mean that downward pressure on yields is starting to abate.

As of yesterday the markets were still giving 100% odds that the Fed would cut thefunds rate by at least 25 basis points on December 11th and the basic explanation for the sharp equity markets rally was that Fed Vice Chairman Kohn supported that view. From our perspective the decline in crude oil futures was also supportive of higherequity prices.

In any event the gold/copper ratio is somewhat thought provoking because it argues that the current time frame may not be quite as similar to the summer of 2006 as we had originally thought.

In the summer of 2006 and again during the summer of 2007 the ratio was ‘low’. In 2006 commodity price weakness pulled yields lower while in 2007 commodity price strength led to weakness in thefinancials which, in turn, pulled yields to the down side.

The point that we are trying to make is that the recovery in the U.S. equity markets coupled with the apparent peak incrude oil pricessuggests that for the time being the downward pressure yields is starting to ease.

The chart below shows the ratio of thestock priceof Mitsubishi UFJ (MTU) to the Nikkei. When interest are declining the Nikkei tends to underperform the S&P 500 Index while MTU does worse than the Nikkei. For the relationship to reverse with MTU leading the Nikkei and the Nikkei leading the SPX we have to get back to an underlying trend that supports upward pressure on yields.

The chart below right shows the ratio betweencrude oiland the CRB Index as well as the ratio between the Asia ex-Japan Index and the Nikkei 225 Index.

The point here is that as long as crude oil prices are rising faster than the CRB Index so that the ratio trends upwards the Nikkei will underperform the other Asian equity markets. Notice that both ratios have turned somewhat lower while the MTU/Nikkei ratio below has risen back to the 200-day e.m.a. and channel top.