Intermarket Analysis Throught Macro and Technical Methods
#3 Commodities Breakout Signals and Long-term Rate Trends
Looking for Setups Through Intermarket Analysis
Continuing with the analysis publish last Wednesday, 05-22, commodities and long term rates , we will attempt to delve deeper into the conclusions we reached. Remember that in that analysis, we examined stock markets segmented by type of economy (developed, emerging, and frontier), and by geographic area, considering the different types of production in each. All stock markets, as of today, have a common pattern. Generally, they are in an upward trend but without volume. It’s like being in a car with little gas left. This is not a sustainable situation over time because it implies that there are few buyers (who are achieving these small increases), mainly due to the absence of sellers. It would only take a few sellers to appear or some buyers to turn into sellers to generate a correction. In technical analysis, this is called a bullish divergence. It is, without a doubt, the most reliable technical signal because it reflects what I just told you. It tells you what will happen; its weakness is that it doesn’t tell you when or how strong it will be.
So, we move on to the commodities markets where we found several “surprises” that we will delve into in this report. From there, we jumped to the bond market to see if it was sending us any messages. Again, “surprises” emerged that are worth exploring further. From that analysis, we obtained two charts that are worth developing.
1. Commodities
We looked at a bunch of commodity charts and indices. The most illustrative one is below. It’s the Bloomberg Commodity Index, in daily frequency, charted using the point and figure method. We deliberately filtered out the time factor. For now, we want to focus on “Price”. What we see, very clearly and with confirmation, at least in this time frame, is an upward breakout supported by increasing volume. The price is moving out of the conflict zone where longs and shorts are disputing their views of “value or fair price.” From a purely technical standpoint, there are several features of the chart that make it more attractive. A downward trend line has been tested 6 or 7 times, with contrary volume spikes in previous testing situations. That is, during the testing, many sellers appeared. This did not happen today; not only that, but a lot of longs also came in.
Has the market expectation changed?
Let’s look at the same Index in a weekly time frame. Notice that by excluding time and focusing on price, what you see below are the weekly closes of the index from 2013 to the present. Of the charts we are going to analyze, this one is probably the weakest from a technical perspective. However, there is a key pattern: the last confirmed trend is bullish.
Time Frames
Peeling back further, let’s delve into the monthly time frame, which implies a setup thinking about a minimum 6-month horizon. Some key data points: from 2013 to the present, that is, over a decade, commodities have traded within a “fixed” range which in this index implies values between 62 and 140. Today, trading at around 123, it’s close to the upper end of the range but with a confirmed upward trend and interesting volume when compared historically with itself.
To filter out sample error, we examined other commodity indices.
- SPGSCI: Very popular in the market but with a completely different composition, weighting, and rebalancing method. The Goldman Sachs Commodity Index (GSCI) is weighted by the global production and consumption of each commodity and is rebalanced more frequently.
The chart is in daily frequency. It broke out of a downward channel, retested, and broke out with volume. A “break” with all the elements. Again, this is the nearest futures contract.
Spot + Future
If we use the spot price, the story is different. See, these are significant discrepancies. The market sees the breakout in the future, but it is not reflected in the spot price, although it is very close. Of course, the market can be wrong, but what we are looking for are these types of messages.
But even in the spot market, on a monthly frequency, we have a breakout message.
To further reduce sample error, we went to a third commodities index: the CRB. Spot price. We published this chart on the feed yesterday. For a pure technical analyst, this is orgasmic. This pattern, which comes from the chartist school, is one of continuity and highly reliable on the break. Since it is spot, the message is consistent. It is at the limit and doesn’t have much time left to decide, either in one direction or the other. It has several attributes because it delimits time, represents continuity patterns, and establishes a potential target.
From Commodities to Long-Term Rates
We believe the market is sending a clear message in commodities. It sees a bullish breakout in futures, confirmed in larger time frames and triggered today by the first chart we saw. This is no small matter. Of course, the commodity index has several sub-indices, and surely not all are in this situation. It’s a matter of digging deeper into the analysis to determine the state of each subgroup. This, of course, translates directly to the macro level through the following identity:
Nominal Rate = Real Rate + Inflation Expectations + Term Premium
The impact on the macro level is emphasized by the correlation between inflation expectations and commodity prices. This correlation, as you can see below, is perfect and unchanging. This is uncommon in financial markets.
All of this brings us directly to the second point we highlighted in last report.
Analyzing the segments of the yield curve, through volume in various ETFs, we observed that the action in the bond market is happening on the long end of the curve. From 20 years onward.
Why?
Macro Identity at work
To delve deeper into the macroeconomic identity:
Nominal Rate = Real Rate + Inflation Expectations + Term Premium
We focused on the term premium. We found another perfect correlation with the 30-year rate.
From Commodities to Long-Term Rates
We have rising short-term inflation expectations and a rising term premium (affecting long-term rates more strongly). Below, we have the 30-year rates vs. F.E.D. funds plotted. Looking at the historical correlation coefficient, we see there is not a very stable relationship between these two variables. Not only is it unstable, but it can also be negative. If we look closely, we see that the current level of correlation is not likely to be maintained over time. History tells us this.
Below is the 30-year rate where we add the time factor through cycle analysis in an attempt to parameterize the relationship described above.
Deeper
What else is the market telling us? The 10-year to 2-year yield spread, the most watched in the market, is going to keep falling. Of course, there are several mathematical options for this to happen. The 10-year rates could fall, the 2-year rates could rise, or a mix of both.
From another technical perspective, we see that the correlation between this spread and the F.E.D rate is two standard deviations above its historical average. To put it clearly, it has traveled too far. This correlation is going to break!
Hypothesis:
In multi-causal mathematics, nothing is linear. That’s the markets for us, especially in assets that have global interferences, like the American yield curve.
The volume in the long end of the yield curve indicates that investors are focusing on the long term. Volume isn’t synonymous with direction but, if it has four legs, a tail, and barks, well, it’s a dog. My macro view leads me to believe that this trend arises from expectations of economic instability, primarily coming through short-term inflationary pressures. Whether or not this is the actual cause, the movement in prices suggests the risk off positioning. Short-term uncertainty means, for certain market participants, going long the high maturity bonds. The market’s reaction, positioning long-term, is clearly defensive. What we call “risk off.”
Porfolio Managing
A serious portfolio manager, especially of large funds and pensions, thinks this way.
“I’ll put xx% in long bonds, which historically are yielding incredibly. I secure a high return on something safe, like U.S. Treasury bonds.”
Why do I think of large funds?
Because that capital isn’t something that’s going to move. It’s a generator of income for a larger pie. For the average person, buying “duration” is a huge risk. If rates go up, you’re out on a stretcher, but for these folks, that’s irrelevant. They’re just looking for return knowing that the capital awaits them at the end of a never-ending road.
Conclusions
- Commodities are technically breaking higher. It’s still early, but there are accumulating technical signals that they are exiting a historic range across various indices. Besides the volume, there’s a technical gem confirming this hypothesis, along with other technical clues.
- This is causing a rise in short-term inflation expectations. The correlation between commodities and these expectations is historically perfect.
- Analyzing the historical correlations between the 30-year rate and the F.E.D rates, we understand that the current correlation cannot be maintained.
- The same argument applies to the spread between the 10-year and 2-year rates.
- The market expects a greater inversion of the curve, at least in the 10-year and 2-year segments.
- The term premium is rising. It has a very high correlation with the 30-year rate and is the only variable that still might be pushing long-term rates higher.
Everything I’m sharing is not intended as a trade or a setup (although the inferred message is clear), but rather as a description of the general situation where setups are born.
Do your job! Find your own trades.
Whew… my head hurts. A lot left for next Wednesday, heh.
Enough for today. I’ll release a piece with part of the theoretical support for this analysis on Friday if possible.
Thanks for reading this far.
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We’ll talk soon.
Martin
Intermarketflow.com
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