Introduction

Throughout history US industrial commodity prices and bond yields have alternated between secular bull and bear trends. History in this case goes back to the mid nineteenth century and a secular trend is defined as one that extends over the course of many business cycles, occasionally spanning thirty or plus years. Primary trends on the other hand, are those that revolve around the so called four year business cycle and mostly range in duration between 9-months-2-years. Since the financial crash of 2008 there has been an intensive discussion amongst economists as to whether the fiscal stimulus and  extraordinary monetary policy (Quantitative Easing, QE I and II) will lead to a significant inflationary wave or whether the system falls into a liquidity trap. A liquidity trap in Keynesian economics develops when easy monetary policies are unable to stimulate an economy, either through lowering interest rates or increasing the money supply, thereby resulting in a deflationary outcome.

Our objective here is not to dwell on the economic arguments, rather to examine the secular trends of commodities, bonds and their inter-market relationship to see what clues the markets themselves may be giving about the inflation/deflation outlook. 

 

Bond Yields

We start with bonds (Chart 1) because yields have been in a secular downtrend (bull market for bond prices) for close to 30-years and in terms of time served are therefore well overdue for a turnaround. The series plotted in the chart is the US Government 30-year constant maturity (TYX) spliced to a 20-year series prior to 1994.

One technique that can help to identify secular trend reversals at a relatively early stage is to construct long-term trendlines on the 240-month Rate of Change (20-year ROC). When such ROC violations are confirmed by a similar trendline break in the yield a reversal signal is triggered. At the present time it is once again possible to construct a line for both series. Since they are intact so is the secular downtrend in yields.

Another way in which secular trend reversals for bond yields can be monitored is to compare the nine month Exponential Moving Average (EMA) of the yield to its 96-month EMA. Bullish and bearish periods identified in this way are represented on the chart by the green and red highlights. It's worth noting that the yield itself has been trading below the average for several decades. It has made many attempts at an upside crossover but each time it has been rebuffed. This reversal ability by the average increases its significance as a dynamic resistance area. When that (EMA/trendline) zone is finally cracked we believe it will signal an end to the current secular downtrend in yields (bull  market for bond prices). Right now, the trendline and moving average are resting in the 4.65% area, and the October 2010 close was 4%.

        Twenty-Thirty Year Government Bond Yields and a 240-month ROC

Chart 1 Source  Pring Turner Capital

A secular reversal signal may be at hand but what of the cyclical trend? In this respect Chart 2 features our Master Yield series, which is constructed from a simple average of government AAA, BAA and commercial paper yields. The KST or smoothed momentum generally reflects the cyclical trend in the Master Yield series quite well. In this respect the arrows show that reversals from an overextended level have, over the last 50-years, offered reliable indications of primary bull markets in yields. Currently the indicator is overextended and therefore perfectly positioned to trigger a primary bull market signal for yields. Given the proximity of recent levels to a secular buy signal we believe such a turn in the tide will be signaled during the course of the current cycle.  Bond owners beware, a new secular bear market for bond prices may be close at hand.

                           The Master Yield and a Long-term KST

Chart 2 Source  Pring Turner Capital

 

Industrial Commodity Prices

One of the problems of identifying secular trends and understanding their characteristics is that there are so few data points. Chart 3 for example, features the CRB Spot Raw Industrials. Since the history of this Index only goes back to 1948 it has been spliced to other data series prior to that date.

                    CRB Spot Raw Industrials and a Price Oscillator

Chart 3 Source  Pring Turner Capital

 

During the last 200-years or so there have been nine secular bull and bear markets as flagged by the arrows. We are now in the tenth. Not all secular trends experience the same characteristics. For example, the mid to late nineteenth century bear was a slow drawn out decline. The 1920-33 trend experienced two sharp down waves compared to the trading range characteristics of the 1980-2000 period. These differing patterns make consistent and timely identification of secular trend reversals a somewhat difficult task. Moving average crossovers, for example can be untimely or subject to unnecessary whipsaws. For this reason the application of smoothed long-term momentum indicators seems to offer a more reliable signal. An example is shown in Chart 3 where a 360-month (30-year moving average) has been divided by a 60-month (5-year) period. Secular momentum buy and sell signals are triggered when the oscillator crosses above and below its  48-month (4-year) moving average. As long as this momentum series is rising it is assumed that the secular trend is bullish and vice versa. Bullish confirmation is given when the price is above its 96-month moving average in which case the plot is highlighted in green. Red highlights develop when both technical measures are negative and black when they are in conflict. Most of these signals have been reasonably accurate but the numerous black highlights remind us that the system is far from perfect. At present the oscillator is rising but is not particularly overextended. That suggests that the secular trend is at a relatively early phase. The signal we would look for to trigger a reversal would be a break below the two converging trendlines and the 96-month moving average, which is obviously some way off. The secular uptrend may be intact but how long is the cyclical part of this trend likely to extend?

      CRB Spot Raw Industrials versus the OECD Leading Indicators

Chart 4 Source  Pring Turner Capital

 

For that we turn to Chart 4, which compares the CRB Spot Raw Industrials to the Organization for Economic Co-Operation and Development (OECD) normalized leading indicators. The OECD composite leading indicator provides early signals of global economic turning points. The green and red highlights indicate when this global economic measure is rising or falling and shows there is an excellent correlation between global economic activity and dollar based industrial commodity prices. Currently the OECD series is moving higher but is moderately overstretched. That suggests that the cyclical bull market has further upside potential. However, the chart shows that the three previous secular up-legs in 1971-4,1975-80 and 2001-2008 indicate that some of the best gains were reserved for the terminal months of those primary bull markets. In those two instances the red highlights show that prices peaked after the OECD series, so the rally may last well into 2011.

 

Commodities Lead Bond Yields at Secular Lows

Long-term trends of commodity prices and bond yields move in the same direction the vast majority of the time, so as a general rule it is usually safe to assume that if commodity prices are in a sustainable uptrend bond yields will be in one as well. Having said that it is also evident that commodities tend to lead bonds at secular turning points.

           Government Bond Yields versus Commodity Prices

Chart 5 Source  Pring Turner Capital

 

We illustrate this in Chart 5, which features government bond yields and commodity prices. The two previous secular bull markets in bond yields were both preceded by a secular low in commodity prices. Of course when we are limited to just two data points we have to be careful about making projections. But the 7-year lead between the 2001 secular low in commodities and that of late 2008 for yields is certainly consistent with the two prior instances.

 

The Commodity/Bond Ratio--the Ultimate Inflation/Deflation Relationship

Chart 6 features the ratio between commodities and bonds, the ultimate inflation/deflation measure. As you can see trendline violations in the past have reliably signaled reversals in the secular trend of this relationship. The ratio has been in a trading range for the last 30-years and is now approaching the upper end for the fifth time. If it punches through such action will represent a major long-term inflationary signal. That's because it will denote the out-performance of commodities over bonds for years to come. Such an outcome appears likely because the long-term momentum oscillator in the lower panel, which is constructed by dividing a 60-month by a 360-month moving average, is in the early phase of a secular advance. Note the green and red highlights are an objective attempt to identify the direction of the secular trend.

            

The Commodity/Bond Ratio and a Price Oscillator

Chart 6 Source  Pring Turner Capital

 

A green highlight is posted when the oscillator is above its 48-month moving average and when the ratio itself is above its 96-month moving average. Red highlights appear when both conditions are reversed and black signifies a neutral period, when the two indicators are contradicting each other. The model is currently signaling a bullish inflationary secular trend and likely commodity out-performance over bonds is just beginning.           

 

 

 

The Commodity/Bond Ratio and a 240-month ROC

Chart 7 Source  Pring Turner Capital

 

Chart 7 shows the same ratio but this time compared to a 240-month ROC. First you can see that its recent 30-year trading range is probably going to turn out to be a reverse head and shoulders pattern, but we obviously need to see the breakout develop before being sure. Second, the two previous secular lows in this relationship have been associated with a breakout from a saucer like bottom in the ROC. The one that developed around 1900 was only obvious after the event as it was not possible to construct a convenient trendline. However, this was possible for the mid twentieth century signal and this will be possible for  the current situation. When the turn does come we will therefore be provided with a timely secular signal for commodities to break out against bonds.

 

The Commodity/Bond Ratio versus Government 20-30 Year Bond Yields

Chart 8 Source  Pring Turner Capital

 

Finally, Chart 8 shows that secular trendline violations in the commodity/bond ratio have usually coincided with those in the 20-year government bond yield series. Currently the secular trend for yields is still down, but if the ratio does break above the upper area of its 30-year trading range the odds of a reversal in yields would be overwhelming.

 

Summary

The secular bear market in bond yields may well be over but it has not yet been signaled by any of our long-term indicators. In the past, secular bottoms in interest rates have been preceded by ones in commodities. That type of set up is certainly consistent with the current situation since commodities bottomed ten years ago. Finally, the ultimate inflation/deflation relationship, that between commodities and bonds is very close to an upside resolution of a 30-year trading range. In the past when major trend breaks of ratio have developed it has represented a timely signal that a secular reversal in one of its components, namely bond yields, has either taken place or is close at hand.

If the breakout does take place we would not only expect to see substantially higher interest rates and commodities but a strong inflation biased finish to this and forthcoming business cycles.

For a movie version of this report please go to Pringturnercapital.com

 

(c) Pring Turner Capital Group

www.pringturner.com