by Kevin Klombies, Senior Analyst, TradingEducation.com, LLC


Thursday, June 26, 2008

Chart Presentation: Third Quarter Shift

Below we show a comparative view of the 10-year U.S. Treasury yield index (TNX) and the CRB Index from the spring of 2006 through into August of 2007.

Around the end of the second quarter in 2006 10-year Treasury yields reached a peak along with commodity prices. In other words the trend for both interest rates and commodity prices peaked around the end of June.

Through the balance of the year interest rates declined as the CRB Index moved lower. While the CRB Index reached bottom in January the trend for 10-year yields remained negative into March.

We are fixating on the details regarding ‘time’ because something very similar and yet completely different transpired last year. To explain we have included a comparison between the TNX and the Bank Index (BKX) from April of 2007 to the present day at bottom right.

Similar to 2006 the top for 10-year yields was reached in June of 2007. Instead of a broad sell off in the commodity markets leading to lower interest rates we can see that pressure came from falling bank shares. Interest rates trended lower from the start of the third quarter in 2007 into March of 2008.

The point is that in both 2006 and 2007 long-term interest rates pushed upwards to a peak around the end of the second quarter only to be hammered lower by weakness in a major market. Interest rates declined from July into the following March only to rise back to a peak into June.

If history were to be kind enough to repeat the argument would be that yields have reached a peak which means that bond prices are set to rally. Why bonds would rally is quite another issue.

The recent tendency has been for a major sector to pivot to the down side at the end of the second quarter. Since it was commodities one year and the financials the year after we suspect that it will be something other than the financials this year. The autos and airlines have already been trashed so we would look for either a return of commodity price weakness- which would go some way towards easing concerns regarding inflationary pressures- or a negative trend that would impact cyclical names such as Caterpillar or consumer products stocks like Apple and Research in Motion. The defense sector may also be vulnerable.

The first image below compares the 10-year Treasury yield index (TNX) with the spread or point difference between the Dow Jones Industrial Index (DJII) and Japan’s Nikkei 225 Index.

At present the DJII is around 11,811 while the Nikkei is last seen around 13,830 which makes the spread close to -200.

In recent years it has made sense to buy the Nikkei each time the spread between the DJII and Nikkei moves to zero. Interestingly enough the major trend changes back in favor of the Nikkei have tended to go with pivots to the upside for long-term yields. While we are still positive on the Japanese equity market history has shown that it has tended to do well when yields are rising.

Below is a rather large chart comparison between crude oil futures and the spread between the S&P 500 Index (SPX) and Amex Oil Index (XOI).

From 1985 into late 2007 the low point for the spread between the SPX and the XOI was almost exactly 50 points. Each time the spread returned to this level crude oil prices were at a major peak. Notice that the collapse in oil prices in both late 1985 and again in 1990 came just after the XOI closed to within 50 points of the SPX.

This is one of the relationships that convinced us that crude oil prices were unlikely to break above 100 last year. If a case can be made for a bubble-like element of speculation in the commodities markets then this chart would argue that it began in earnest during the final quarter of last year after crude oil prices approached and then broke above 100.

In a sense we are deep within uncharted waters but our sense is that anything above 100 for crude oil will prove to be temporary and that once the oil stocks start to lose strength relative to the broad market the correction will swing the XOI back to hundreds of points below the SPX.

Kevin Klombies is a prolific writer and market analyst specializing in the commodity stock market and bond commodity market trading in the energy sector. He  graduated in 1980 from the University of Saskatchewan with a Bachelor of Commerce degree (Honours) in Finance/Economics.  Click here for full bio >>