by Kevin Klombies, Senior Analyst TraderPlanet.com
Wednesday, October 10, 2007
Chart Presentation: The Details
There are now sixteen trading days left before the next Federal Reserve Open Market Committee meeting (Oct. 31) and as of yesterday the odds of a rate cut to 4.5% had fallen to roughly 36%. Over the past year or so downward pressure on interest rates has been created through rather intense weakness in commodity prices or, when commodity prices have risen, by even more intense pressure on the financial sector.
Our point is that the markets can create an incentive for the Fed to cut the funds rate by either hammering energy and metals prices lower or by allowing them to rise until we end up a reprise of the subprime crisis. The former goes with a stronger U.S. dollar while the latter would definitely go with a weaker currency trend.
The charts at right compare the S&P 500 Index (SPX) with crude oil futures. The chart at top right shows the time frame between late February and October of 2006 while the chart below right is from the present time period.
When crude oil prices began to rise in March of 2006 it created the lower edge of a declining trading channel. Around the time that the SPX broke through the top of this channel in late July oil prices were very close to turning lower.
By the time the SPX returned to the May highs in September crude oil prices had fallen all the way back to the original starting point around 60.
The argument is that concentrated strength in oil prices creates offsetting downward pressure on the U.S. equity market. Last year as oil prices moved from 60 up to roughly 78 and back to 60 the SPX swung from 1330 down to 1220 and then back to 1330.
A similar trend developed this year when crude oil prices once again began to lift upwards from just above 60. The SPX created a downward sloping trading channel that carried the equity markets lower into August. By mid-September as crude oil prices moved above 80 the SPX broke through the top of the trading channel.
Our expectation was that the SPX would be ready to make new highs around the time that oil prices moved back towards 60 but at present we find the SPX escaping to the upside even as oil prices hover around 80. While the devil is always in the details if history were to repeat we could still see crude oil futures back closer to the 60 level by the time the Fed meets next to decide on interest rates.
The chart below compares 10-year Treasury yields with the sum of copper futures and crude oil futures.
The relationship is close to as basic as one is going to find in the markets. Strength in energy and metals prices goes with higher long-term interest rates and weakness in energy and metals prices goes with lower long-term yields.
The markets can wander off in different directions for short periods of time but the idea is that in general if copper and crude oil prices are making new highs we should expect higher yields and lower bond prices. Conversely if cyclical growth is weaker so that energy and metals prices are declining- as was most certainly the case in 1997 and 1998- then yields will decline. Fair enough.
This brings us to the chart at bottom right which shows the current time frame for this relationship. The point is that through 2006 everything was working much as one might expect but through 2007 markets and prices have been moving almost randomly. Strength in energy and metals prices should have pushed yields higher but it appears that leverage in the banking and shadow banking systems is incapable of dealing with rising interest rates.
The chart below shows the chart of Boston Scientific (BSX) and the yield spread or difference between 10-year and 3-month Treasury yields. The spread defines the yield curve and when it is below the ‘0’ line it means that 10-year yields are lower than 3-month yields.
The yield curve flattened from early 2004 into 2006 as the Fed raised short-term interest rates in the face of strong commodity prices. At present the yield curve is steepening rather dramatically as long-term yields attempt to rise even as short-term yields move lower. Our quick thought is that regardless of what is happening to bond prices on any given day what the market is attempting to do- with some success- is widen the yield spread.