by Kevin Klombies, Senior Analyst

Thursday, August 9, 2007

Chart Presentation: Bonds

We have included four charts of the U.S. 30-year T-Bond futures. The charts, from top to bottom, cover the time frame between March through December in 2004, 2005, 2006, and 2007.

We showed this comparison a month or two ago when the TBond future were pushing lower in price. The inspiration for the perspective came in large part from the certainty that many economists and strategists were communicating with regard to lower bond prices and higher Treasury yields. Wall Street, it would seem, loves to extrapolate trends.

We argued in passing that in each of the last three years the trend for the bond market had reversed around the end of the second quarter. In 2004 bonds were weaker in price into June and then stronger through October while in 2005 the trend reversed from higher to lower. In 2006 bond prices were weak through June before reversing back to the upside.

With this template in mind we suggested that even though many expected bond prices to continue to tumble a reasonable case could be made for higher bond prices in July. We went on to suggest that if history were kind enough to repeat the TBond futures should return to the 200-day e.m.a. line by the first week in August.

It was an interesting call made, we suspect, with only moderate conviction. It was also made without much in the way of thought regarding what it would likely mean for the equity markets. In other words… what would have to happen to or in the markets to reverse the trend for bond prices and snap the TBond futures back into the 110- 111 range over the course of only a few weeks? With the benefit of hindsight we now know the answer.

Our purpose in returning to these charts is not to point out that we were actually correct for a change (blind pigs, corn, that sort of thing) but rather to do a ‘Wall Street’ and extrapolate on the point. Consider that in all three cases- 2004, 2005, and 2006- once bond prices changed trends at the end of June the new trend extended through at least October. In other words while the TBonds were rather rudely hit for a 1 8/32 loss yesterday the charts argue for higher bond prices into the fourth quarter. The question would then be… what does this portend for the equity market and/or the U.S. economy? Our view is that this is the markets’ way of saying that one or more cyclical sectors are going to show significant weakness through the balance of the year with our favored outcome being much lower energy and metals prices.





Equity/Bond Markets

For those who might not have noticed we are negative on commodity prices in general and energy and metals prices in particular. We were negative yesterday, last week, and even at the beginning of the year when crude oil futures prices were touching 50. We have no reason to change that view but we do expect that when we eventually turn positive we might well be one or two years early. We hope not.

The chart compares crude oil futures with an overlaid chart of the Dow Jones Industrial Index (blue line) and the sum of the share prices of Citigroup (C) and Wal Mart (WMT) (black line). The idea is that C and WMT tend to trend with the DJII but will lag until oil prices finally stop rising. Notice how the lines diverged into the oil price peak in 1997 and how the lines have been diverging since 2005. The basic point is that eventually/one of these days/possibly this week crude oil prices will turn lower so that WMT and C can ‘catch up’.

The charts at middle and bottom compare WMT with crude oil futures times the Canadian dollar futures. The CAD trend with crude oil and when both are strong and rising- as they were through the end of 1996 (middle chart) the stock price of WMT tends to decline. The very quick point is that over the past few days in response to the minor decline in the crude oil times CAD combination… the stock price of WMT has begun to rise. Not a lot, of course, but just enough to make this interesting.

Quickly… there used to be a theory or argument that the Fed should adjust the funds rate based on the Dow Jones Spot (Commodity) Index. If the DJS was above 128 the Fed should tighten and if was below 119 they should ease. We have no idea what they should do when the DJS is pushing 320 but we suppose that is why the Fed continues to worry about inflation. In any event… there is about 0% chance of a lower funds rate as long as the DJS is still rising. If the recent peak marked the cycle highs then similar to 1997 it will indicate that it is time for short -term yields to start to decline.