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 experts of the ratio analysis have been in great demand since recently according to the information provided by job search web sites. Ratio analysis will be briefly introduced in this section but will be covered more extensively in Chapters 11 and 12.
Figure 3.13 is divided into two parts. 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.)
THE BOTTOM CHART IS A RATIO OF THE CRB INDEX DIVIDED BY TREASURY BOND PRICES FROM 1987 THROUGH OCTOBER 1989. A RISING RATIO SHOWS THAT COMMODITIES ARE OUTPERFORMING BONDS AND IS INFLATIONARY. A. FALLING RATIO FAVORS BONDS OVER COMMODITIES AND IS NONINFLATIONARY.
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 UPPER CHART COMPARES PRICES OF TREASURY BILLS AND TREASURY BONDS. THE BOTTOM CHART COMPARES THE CRB INDEX TO PRICES IN THE UPPER CHART. MAJOR TURNING POINTS IN TREASURY BILLS CAN BE HELPFUL IN PINPOINTING TURNS IN BONDS AND THE CRB INDEX. DURING MARCH OF 1988, BILLS AND BONDS TURNED DOWN TOGETHER (WHILE COMMODITIES BOTTOMED). IN THE SPRING OF 1989, A MAJOR UPTURN IN T-BILLS MARKED A BOTTOM IN BONDS AND WARNED OF AN IMPENDING BREAKDOWN IN COMMODITIES.
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.