The use of relative-strength analysis
Bond market can be found by monitoring the trend action in the T-Bill market.
"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 which can be rather difficult to make head or tail of without the help of the experts - can be found via job search web sites or on some financial sites. 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. The
respective roles of the individual commodities will be discussed in Chapter 7.
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 alluded to earlier in the chapter.
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.
SUMMARY
This chapter presented graphic and statistical evidence that commodity prices,
represented by the CRB Index, trend in the same direction as Treasury bond yields and
in the opposite direction of bond prices. Technical analysis of bonds or commodities
is incomplete without a corresponding technical analysis of the other. The relative
strength between bonds and the CRB Index, arrived at by ratio analysis, also provides
useful information as to which way inflation is trending and whether or not the
investment climate favors financial or hard assets.
