THE USE OF RELATIVE-STRENGTH ANALYSIS
There is another technical tool which is especially helpful in comparing bond prices to commodity prices: relative strength, or ratio, analysis. Ratio analysis, where one market is divided by the other, enables us to compare the relative strength between two markets and provides another useful visual method for comparing bonds and the CRB Index.
The upper portion is an overlay chart of the CRB Index and bonds for the three-year period from late 1986 to late 1989. The bottom chart is a ratio of the CRB Index divided by the bond market. When the line is rising, such as during the periods from March to October of 1987 and from March to July of 1988, commodity prices are outperforming bonds, and inflation pressures are intensifying. In this environment financial markets like bonds and stocks are generally under pressure. A major peak in the ratio line in the summer of 1988 marked the top of a two-year rise in the ratio and signaled the peak in inflation pressures. Financial markets strengthened from that point. (Popular inflation gauges such as the Consumer Price Index—CPI—and the Producer Price Index—PPI— didnt peak until early 1989, almost half a year later.)
In mid-1989 the ratio line broke down again from a major sideways pattern and signaled another significant shift in the commodity-bond relationship. The falling ratio line signaled that inflation pressures were waning even more, which was bearish for commodities, and that the pendulum was swinging toward the financial markets. Both bonds and stocks rallied strongly from that point.
THE ROLE OF SHORT-TERM RATES
All interest rates move in the same direction. It would seem, then, that the positive relationship between the CRB Index and long-term bond yields should also apply to shorter-term rates, such as 90-day Treasury bill and Eurodollar rates. Short-term interest rates are more volatile than long-term rates and are more responsive to changes in monetary policy. Attempts by the Federal Reserve Board to fine-tune monetary policy, by increasing or decreasing liquidity in the banking system, are reflected more in short-term rates, such as the overnight Federal funds rate or the 90-day Treasury Bill rate, than in 10-year Treasury note and 30-year bond rates which are more influenced by longer range inflationary expectations. It should come as no surprise then that the CRB Index correlates better with Treasury notes and bonds, with longer maturities, than with Treasury bills, which have much shorter maturities.
Even with this caveat, it's a good idea to keep an eye on what Treasury bill and Eurodollar futures prices are doing. Although movements in these short-term rate markets are much more volatile than those of bonds, turning points in T-bill and Eurodollar futures usually coincide with turning points in bonds and often pinpoint important trend reversals in the latter. When tracking the movement in the Treasury bond market for a good entry point, very often the actual signal can be found in the shorter-term T-bill and Eurodollar markets.
As a rule of thumb, all three markets should be trending in the same direction. It's not a good idea to buy bonds while T-bill and Eurodollar prices are falling. Wait for the T-bill and Eurodollar markets to turn first in the same direction of bonds before initiating a new long position in the bond market. To carry the analysis a step further, if turns in short-term rate futures provide useful clues to turns in bond prices, then short-term rate markets also provide clues to turns in commodity prices, which usually go in the opposite direction.
THE IMPORTANCE OF T-BILL ACTION
One example of how T-bills, T-bonds, and the CRB Index are interrelated can be seen in Figure 3.14. This chart compares the prices of T-bill futures and T-bond futures in the upper chart with the CRB Index in the lower chart from the end of 1987 to late 1989. It can be seen that bonds and bills trend in the same direction and turn at the same time but that T-bill prices swing much more widely than bonds. To the upper left of Figure 3.14, both turned down in March of 1988. This downturn in T-bills and T-bonds coincided with a major upturn in the CRB Index, which rose over 20 percent in the next four months to its final peak in mid-1988.
The bond market hit bottom in August of the same year but was unable to gain much ground. This sideways period in the bond market over the ensuing six months coincided with similar sideways activity in the CRB Index. Treasury bill prices continued to drop sharply into March of 1989. It wasn't until T-bill futures put in a bottom in March of 1989 and broke a tight down trendline that the bond market began to rally seriously. The upward break of a one-year down trendline by T-bill futures two months later in May of 1989 coincided exactly with a major bullish breakout in bond futures. At the same time the CRB was resolving its trading range on the downside by dropping to the lowest level since the spring of the previous year.
In this case, the bullish turnaround in the T-bill market in March of 1989 did two things. It gave the green light to bond bulls to begin buying bonds more aggressively, and it set in motion the eventual bullish breakout in bonds and the bearish breakdown in the CRB Index.
"WATCH EVERYTHING"
The preceding discussion illustrates that important information in the bond market can be found by monitoring the trend action in the T-Bill market. It's another example of looking to a related market for directional clues. To carry this analysis another step, T-Bills and Eurodollars also trend in the same direction. Therefore, when monitoring the short-term rate markets, it's advisable to track both T-Bill and Eurodollar markets to ensure that both of them are confirming each other's actions. Treasury notes, which cover maturities from 2 to 10 years and lie between the maturities of the 90-day T-bills and 30-year bonds on the interest rate yield curve, should also be followed closely for trend indications. In other words, watch everything. You never know where the next clue will come from.
The focus of the previous paragraphs was on the necessity of monitoring all of the interest rate markets from the shorter to the longer range maturities to find clues to interest rate direction. Then that analysis is put into the intermarket picture to see how it fits with our commodity analysis. A bullish forecast in interest rate futures should be accompanied by a bearish forecast on the commodity markets.
Otherwise, something is out of line. This chapter has concentrated on the CRB Index as a proxy for the commodity markets. However, the CRB Index represents a basket of 21 active commodity markets. Some of those markets are important in their own right as inflation indicators and often play a dominant role in the intermarket picture.
' Gold and oil are two markets that are inflation-sensitive and that, at times, can play a decisive role in the intermarket picture. Sometimes the bond market will respond in the opposite direction to any strong trending action by either or both of those two markets. At other times, such as in the spring of 1988, during the worst drought in half a century, the grain markets in Chicago can dominate. It's necessary to monitor activity in each of the commodity markets as well as the CRB Index.
SOME CORRELATION NUMBERS
This work so far has been based on visual comparisons. Statistical analysis appears to confirm what the charts are showing, namely that there is a strong negative correlation between the CRB Index and bond prices. A study prepared by Powers Research, Inc. (Jersey City, NJ 07302), entitled The CRB Index White Paper: An Investigation into Non-Traditional Trading Applications for CRB Index Futures (March, 1988), reported the results of correlation analysis over several time periods between the CRB Index and the other financial sectors. The results showed that over the 10 years from 1978 to 1987, the CRB Index had an 82 percent positive correlation with 10-year Treasury yields with a lead time of four months.
In the five years from 1982 to 1987, the correlation was an even more impressive +92 percent. Besides providing statistical evidence supporting the linkage between the CRB Index and bond yields, the study also suggests that, at least during the time span under study, the CRB Index led turns in bond yields by an average of four months. In a more recent work, the CRB Index Futures Reference Guide (New York Futures Exchange, 1989), correlation comparisons are presented between prices of the CRB Index futures contract and bond futures prices. In this case, since the comparison was made with bond prices instead of bond yields, a negative correlation should have been present. In the period from June 1988 to June 1989, a negative correlation of -91 percent existed between CRB Index futures and bond futures, showing that the negative linkage held up very well during those 12 months.
The 1989 study provided another interesting statistic which takes us to our next step in the intermarket linkage and the subject of the next chapter—the relationship between bonds and stocks. During that same 12-month period, from June 1988 to June 1989, the statistical correlation between bond futures prices and futures prices of the New York Stock Exchange Composite Index was +94 percent. During that 12-month span, bond prices showed a negative 91 percent correlation to commodities and a positive 94 percent correlation to stocks, which demonstrates the fulcrum effect of the bond market.
The numbers also demonstrate why so much importance is placed on the inverse relationship between bonds and the commodity markets. If the commodity markets are linked to bonds and bonds are linked to stocks, then the commodity markets become indirectly linked to stocks through their influence on the bond market. It follows that if stock market traders want to analyze the bond market (and they should), it also becomes necessary to monitor the commodity markets.
Read More : Technical Analysis Of Commodities And Bonds
