Besides pattern recognition, trend analysis, and Fibonacci retracements, one of the areas you study in technical analysis is the relationship between asset classes. We call it intermarket analysis. Fundamental CFA analysts study the relationship of the business cycle and leading economic indicators on the different asset classes as well. In normal economic conditions we have relationships that have been established with high correlation studies over the last 40 years that have held up well, such as currencies and commodities trending in opposite directions. Rising commodity prices follow inflationary fears which cause bonds to fall and interest rates to rise. Sometimes the different asset classes can diverge from the normal relationships, but they don’t tend to do it for very long. Bonds, stocks, and commodities have not been following their usual correlations in 2014, but that looks to be changing.
Intermarket Analysis
First, let’s talk about the intermarket relationships and where we are now:
Commodities, Bonds, and Interest Rates
- Commodities trend in the opposite direction of bond prices
- Interest rates and bonds are inversely correlated
- Rising commodities correlate with rising interest rates and falling bonds
- Falling commodities correlate with falling interest rates and rising bonds
Stocks and Bonds
- Stocks like falling interest rates
- Normally, bonds rise with stocks
- Bonds lead stocks
- During bouts of deflation, bonds rise as stocks fall
Stocks and Commodities
- Rising stocks discount economic strength which increases demand on commodities
- Rising stocks lead rising commodity prices
- If the dollar is falling and commodity prices are rising, it’s eventually going to be bad for the consumer and eventually stocks
The business cycle plays a large part on these relationships, but I don't want to get too technical here. Deflation, stagflation, expansion, and contraction as well as central bank intervention can jumble these relationships some, but more often, the relationships above hold true to their historical correlations.
The Last Few Years in Commodities and Bonds
For the past three years, commodities have been falling while interest rates and bond prices have been rising. The relationship held true to its historical correlation. China has had slowing growth. After the first half of 2011, there was a concern that the US was going back into a recession. Europe’s Sovereign Debt Crisis from 2010-2012 was a contributor. European stocks went basically sideways from 2011 to 2013. Over the past five years, some of the volatility can be explained by sporadic bouts of central bank intervention and withdrawal as policy makers used new tools with untested results.
Last year, fear of rising interest rates due to the Federal Reserve’s proposed taper program permeated throughout Wall Street. The 10-year Treasury yield rose toward 3% from 1.5%, leading up to the September Federal Open Market Committee (FOMC) meeting. During a brief period, commodities rose as bonds fell from May to September. 2013 was a text book chart example of how commodities, bonds, and interest rates typically correlate (shown below).
Recent Trends
When the program was officially announced last December, it appeared as though the yield curve would steepen and long-term interest rates were back up to 3%; however, weather conditions have thrown some additional variables into the taper equation. Recent events of both commodities and bonds rising while interest rates fell during the first two months of 2014 are abnormal, and I don’t believe this relationship will continue for much longer.
To reiterate, bond prices trade in the opposite direction of commodities during normal economic conditions. They can both trade in the same direction, but this is typically only during a short transition.
Recent conditions show that commodities are in a full-fledged rally along with bond prices including corporate bonds and Treasuries. I believe this is a result of two issues that are tied together:
- Interest Rate/Taper Trade was over subscribed
- Winter conditions have slowed the economy
The taper trade or rising interest rate trade that started mid-2013 was the selling of consumer staples, high yield stocks, bonds, real estate investment trusts, and utilities – assets that are negatively correlated to interest rates. As soon as the Fed implemented a curtailment to their purchase program of Treasury and agency-backed securities last December, no sooner did economic numbers begin to fall due to the harsh winter conditions. The Flash PMI numbers in January for China also spooked investors when they turned into contractionary readings. Economic factors essentially reversed the taper trade as interest rates fell and bonds rose due to the weak economic numbers. Don’t forget too that there was a loud debate going on in January about the valuation of the market by Wall Street. Take, for example, comments made by Goldman Sachs equity strategist David Kostin when he cited the market as “Lofty by almost any measure," which put investors on high alert the week of January 13th.
It’s pretty clear during February that investors started to give U.S. stocks the benefit of the doubt concerning economic conditions. It was repeated over and over during the earnings season that many companies blamed weakness due to store closings and harsh weather conditions that kept the consumer at home. Since then, economic results have been mixed but mostly still down in January and February.
A possible third issue dangling from the media is the Russia and Ukraine dispute and how involved the US intends to get. An international crisis tends to see investment flow into U.S. Treasuries and gold, but it may spread to other asset classes as well. Fears entered the market on this regard, but have since calmed. This still remains a fluid area of market concern and can change in a moment’s notice. I don’t believe any investment manager or analyst fully understands the situation and can make long-term investment decisions based on current events. I hardly think US investors and portfolio managers knew Crimea was on the map until the last two weeks.
To summarize, recent weather conditions, economic indicators, and concerns over valuations have caused investors to flock back into the interest rate sensitive investments. Bonds are rising as yields fall and commodities are showing signs of long-term technical bottoms. At the same time, stocks are rising too as investors discount the return of normal weather conditions and a snap-back rally in consumption. Bonds are rising, stocks are rising, and commodities are rising. That’s not normal.
In the last week, however, things have changed as the economic indicators have shown improvement and fears over Ukraine contagion have simmered down. Eventually the weather will warm up and consumers will bounce back. Bonds have retreated as rates have risen, but one week doesn’t make a trend. Investors will need to continue to see improvement in the economic indicators to continue to believe that weather was to blame. If that’s the case, look for the resurgence of the taper trade (rising interest rates) which would be bullish for financials (which have ticked up this week) and bearish for investments negatively correlated to interest rates as I described above (note the big sell off in utilities over the past two weeks).
Sector Peformance Relative to the S&P 500
The rotations have been intense over the past two months in utilities, financials, and consumer stocks. Stay nimble and watch commodities as this trend continues to improve.
