Intermarket Analysis: Perspective on Inflation, Deflation

by J. Clinton Hill, The Market Direction at hillbent.com

Some friends/professional peers sent me a couple timely and interesting articles related to topics on bonds, inflation, and liquidity traps. If you have the time, I highly recommend reading them:

Bill Gross On Minsky’s Take Of The Liquidity Trap: From “Hedge” To “Securitised” To “Ponzi”

Huggies Price Cut Shows Why Bond Market Backs Bernanke QE3

One friend is a professional trader based out of Europe and the other is a CFA analyst on the east coast. Both more or less wanted to know my take on either of these articles, so today’s post essentially shares my earlier reply to their communication. I answered with the following email comments:

“Thanks for sharing the Bloomberg and ZeroHedge articles. After reading them, I find myself inspired to consider this from a technical analysis perspective, which is my core strength. I hope that my ‘two cents’ can help to move this dialogue forward or at least contribute another piece to the puzzle.

To begin, I revisited an asset class intermarket analysis report on relative performance which I generated over my weekend ritual of technical and quantitative analysis. As far as the table is concerned, the column for 10-Year Treasury Note futures merely shows the evolving relative strength relationship to other assets.

(Note on the table below that the horizontal axis for asset classes represents a long position while the vertical axis represents a short position, i.e. the difference in performance. I have selected various time periods spanning from 5 to 200 days. If you look at the column for the 10-Year Treasury Note (futures bond price performance and not to be confused with 10-Year Treasury Rates) and you can cross-reference it to the commodities row or other assets in the matrix.)

(Also, note that I have not yet inserted the data and formulas to generate SP-500 correlation values for asset classes. For the purpose of this discussion, it is not so relevant.)

Next, I decided to take a look at a couple weekly charts to evaluate the relationship between bond prices (TLT) and consumer staples (XLP) and commodities (DBC).

The first chart depicts the weekly performance trends of bond prices (TLT) vs. the Consumer Staples exchange traded fund (XLP). My rationale for using the XLP lies in the assumption that when we encounter inflation, demand for staples tends to be less elastic than discretionary items (which self-correct supply/demand imbalances after extreme price movements).

1. The first thing one should observe on this chart is the cyclical upward and downward movements of this price relationship, regardless of the overall trend.
2. While mentioning the overall trend, one can see that the TLT/XLP spread broke its bearish channel @ July-2011, but has faded since testing 2010 resistance levels. We currently have a consolidation phase between these two markets. If Fed Chairman Bernanke’s deflation worries hold any water, then the trajectory of this chart should move upward, not downward.
3. Based upon stochastic indicators, this spread is oversold and while I do not profess to divine the future, historical patterns favor another upward move.

The second chart represents the performance spread between bonds (TLT) and commodity prices (DBC). After breaking above the curve of a long-term bearish slope, the market for this spread has a bias towards consolidation. It too is oversold and the odds favor a continuation of the recently established uptrend. To be prudent, one should wait for a price confirmation from the chart itself.

(See charts below…)

Lastly, since bond prices are ultimately determined by interest rates, it would be remiss of me not to at least mention them (see charts below). In the interest of time, I will keep my comments very brief.

1. 10-Year and 30-Year Treasury rates are both exhibiting descending triangle patterns on their weekly charts. Statistically, odds tend to favor bullish breakouts for descending triangles.
2. With the secular or long-term trends for treasury rates being so bearish, I am more or less neutral in this instance.
3. However, I will say this: any violation of the support lines or previous lows could send us into uncharted territory of new historical lows.
4. An above such scenario would indeed be bullish for bonds. Clipping another 100 basis points from existing rates, give or take a quarter, would trigger a nice upward move in bonds.
5. Remember, most traders and some investors tend to lever bond positions, so while the distance from the curb to the ground is not far, any remote signs or smell of more Fed ‘love-for-sale’ (aka QE3) will attract a considerable number of snorting bond bulls in lust for potential upside appreciation.

Well, there’s my opinion guys. It may not address the questions to which you seek answers, but, hopefully, it provides some guide posts for navigating the capital markets. When all is said and done or not done, price and price relationships between assets or sectors are the bottom line on where we, i.e. the market, are at or headed.”

Signing off and still Hillbent on the Market Direction…