Macro Technical Analysis - Bianco Research

Macro Technical AnalysisPresented to the IFTA 1999 Conference

October 19, 1999

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Long-Term Interest Rates - 1900 to 1999

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About This Presentation

Contrary to the beliefs of many hard line technical analysts who rely solely upon the“holy six” market elements (high, low, open, close, volume, and open interest), Jim hasfound that certain fundamental data, such as earnings and economic releases, canprovide an edge in market forecasting. Using numerous examples from the bond market,Jim will show you how to create an effective bond trading strategy which incorporatesboth fundamental data and technical analysis. He will also explain why somefundamental data, such as inflation, is NOT useful in market projection.

Jim will also address the effects of commodity prices on bond yields, how the ratio of theequity market’s capitalization as a percentage of nominal gross domestic product affectsprice performance of the stock market, the role government regulation plays indetermining inflation, how market performance affects mutual fund investors, the rolepolitics plays in setting interest rates, and measuring the stock and bond markets from atotal-return perspective.


About The Speaker

James Bianco is President of Bianco Research, LLC, an Arbor Research & Trading, Inc.affiliate.

He was National Vice President of the Market Technicians Association in 1996.

His work is devoted primarily to the fixed income markets, emphasizing the money flowcharacteristics of primary dealers, mutual funds, hedge funds, futures traders, banks, andinstitutional investors.

Prior to joining Arbor and Bianco Research, Jim spent five years in New York, as amarket strategist in equity and fixed income research at UBS Securities and as an equitytechnical analyst with First Boston and Shearson Lehman Brothers.

Jim has spoken at many investment conferences and is regularly featured in “A-List”investment publications, including the Wall Street Journal, New York Times, Barron’s, USNews and World Report, BusinessWeek, Forbes, and Fortune (among others) as well asall the major newswires.

He does a weekly commentary for CNNfn, has made frequent appearances on CNBC,and has written articles for Stocks and Commodities, Financial Trader and Futuresmagazines.


Major Themes

• The Three Components of Price Movements:Cycle, Trend and Noise

• What Doesn’t Work?Inflation or Real RatesThe Dollar or Foreign Activity in U.S. Markets

• What Does Work?The Wealth EffectHow Stocks Are Changing The WorldBond Rally Only When Stocks Fall


The Three Components of Price Movements

• Cycle - This is the “big picture”

• Trend - This is where our presentation is mostrelevant.

• Noise - This is where most day traders operate.Our presentation will not deal in this area directly.


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• The reasons for the carnage are clear. Much of the blame traces to the two recent moves by the FederalReserve to raise key interest rates to cool the red-hot economy, and concern about rising inflation. -- WallStreet Journal, 9/13/99

Real Rate Myth• The real rate theory can trace its roots back to 1810 when British monetary theorist Henry Thornton

observed that, “In countries where the currency was in rapid depreciation, the rate of interest should beproportionately augmented.” So, the idea of real rates is not exactly new.

• The modern interpretation of the real rate theory was proposed by Irving Fisher (Appreciation and Interest,1896; The Theory of Interest Rates, 1930) in which he stated that interest rates were comprised of twocomponents: 1) A rent on capital or a “real” rate and 2) a premium based in the expected change in prices.Building upon this were studies in 1969 by the Federal Reserve Bank of St. Louis and 1970 by MorganGuaranty Trust. The St. Louis study, “Interest Rates and Price Level Changes, 1952 to 1969” by Yohe andKamosky found that during the period of the study (see chart) a 3% premium over inflation prevailed. Thesecond report, “How to Get Interest Rates Down” by Ralph Leach showed similar results in testing the realrate theory during the 1960s.

• After the publication of these reports the “3% interest rate premium” became dogma in the investmentcommunity. It is so accepted now that few bother to question it. However, as the chart shows, the onlytime this theory appeared to work was from the early 50s to the late 60s -- exactly the period of the studiesmentioned above. During most of the years shown, and especially since 1970, real rates have not showna tendency to adhere to this theory. In fact, the only time since 1981 that real yields havebeen below 3% was September to December 1990 – the beginning of the best bull marketof the 1990s.


Some statistics about Real Rates (through December, 1998)

Correlation: LT Largest LargestPeriod Median Average Std Dev +1 Std Dev -1 Std Dev % Negative Rates and YOY CPI Positive Date Negative DateSince 1801 4.53% 4.64% 6.00% 10.64% -1.36% 12.25% -2.50% 21.23% 1802 -21.22% 19181800 to 1913 7.17% 6.84% 5.38% 12.22% 1.46% 4.68% 38.18% 21.23% 1802 -20.80% 1864Since 1913 2.50% 1.77% 5.55% 7.32% -3.77% 22.11% 71.25% 21.21% 1921 -21.22% 1918

Correlation: LT Largest LargestPeriod Median Average Std Dev +1 Std Dev -1 Std Dev % Neg. Rates & YOY CPI Positive Date Negative DateSince 1914 2.47% 1.74% 5.56% 7.30% -3.83% 22.35% 22.88% 21.21% Jun-21 -21.22% Aug-18Since WW II 2.50% 1.74% 3.83% 5.57% -2.09% 18.56% 32.98% 8.86% Aug-83 -17.48% Mar-47Morgan & Fed Study 2.49% 2.17% 0.97% 3.14% 1.21% 5.88% 54.64% 3.73% May-59 -0.47% Mar-57

Since Sept. 1981 4.60% 4.97% 1.49% 6.46% 3.47% 0.00% 69.27% 8.86% Aug-83 2.19% Dec-90


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Long Term Interest Rates and Year-over-Year Change in CPI Back to 1914

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"Real" Long Term Interest Rates Back to 1914

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This chart shows no consistent relationshipexists between the Yen/Dollar and the yield ofthe 5-year Treasury Note. This runs counter toconventional wisdom.

The top panel of this chart shows theYen/Dollar exchange rate overlaid on the yieldof the 5-year Treasury Note. The secondpanel is a rolling two-month correlation ofthese series. The third panel is a rolling 60-month correlation of these series. Neither ofthe two bottom panels shows a consistentrelationship.

Yen/Dollar versus 5-Year Treasury Note Yields

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Percentage of Foreign Trading in U.S. Treasury Notes and Bonds(12 Month Sum)

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For All Foreign Countries:Net Purchases of All U.S. Securities Less U.S. Treasury Notes and Bonds (Line) and

Net Purchases of U.S. Treasury Notes and Bonds Only (Bars)12 Month Rolling Sum

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Stock Market Capitalization As A Percentage Of Nominal GDP

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Dec-72 = 78.1%Nov-68 = 77.8%Aug-29 = 81.4%

Apr-4216%

Sep-7433.7%

Jul-8233.5%

Last (June): 159.05%


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We use this chart to show the amount of wealththe stock market has created over the last twoyears. As of June 30, 1999, the two-yearincrease in the stock market’s capitalizationsurged by $4.934 trillion or, 56% the size ofnominal GDP

As this chart shows, when the two year increasein the stock market’s capitalization is expressedas a percentage of nominal GDP, recent gainsare the largest ever seen. To appreciate howlarge these gains are, consider that they arelarger than M2, larger than all the assets in thebanking system ($4.5T) or, almost as large asthe most popular bond market benchmark index,the Lehman Aggregate Index ($5.4T).

Dow Jones Industrial Average

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The Yield of the Moody’s Aaa Bond Index (20-Year)

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Rolling 1 Year Correlation Of The Weekly DJIA Change And The Weekly Moody’s Aaa Bond Yield Change

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+RZ�6WRFNV�$UH�&KDQJLQJ�7KH�:RUOGDow Jones Industrial Average

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Rolling 1 Year Correlation Of The Weekly DJIA Change And The Weekly Moody’s Aaa Bond Yield Change

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This chart shows the relationship betweenstock prices and interest rates. The top panelshows the stock market (Dow JonesIndustrial Average - DJIA). The middle panelshows interest rates (the yield of the Moody’sAaa Bond Index). The bottom panel shows arolling 52 week (1 year) correlation of theweekly change of the stock market and theweekly change of interest rates.

For the 30 years ending in the summer of1997, the correlation between changes instock prices and the changes in interest rateswere almost always negative. This meansthat stock prices would rise when interestrates were falling and vice versa. One couldargue as to which market leads and whichfollows, but the fact is that stock prices andinterest rates had a consistent inverserelationship with each other.

Starting in July of 1997, the correlationbetween stocks and bonds began its mostdramatic change ever. The correlationmoved from very negative to positive,suggesting that stocks and interest rates arenow moving in the same direction.

How large is this change? This chart tracesthis relationship back to 1923. Note that thecorrelation peaked at its most positive ever --40% on 12/15/98.


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DJIA Draw Down

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Nearest Bond Futures

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Dow Jones Industrial Average

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11,500This chart shows the relationship between stocksand bonds over the last 2 years.

The top panel is the DJIA. The middle panel is a“drawdown” chart of the DJIA. A drawdown chartmeasures how far the DJIA is from its all-time high(a reading of 0% means a new all-time closing high).The bottom panel is the nearest bond futurescontract.

This chart has five boxed periods. These are thefour largest bond rallies since mid-1997.

Note that no bond rally in the last 2 years hasoccurred when stock prices were rising. Whenstocks were making new all-time highs, bonds wereeither declining or, at best, trending sideways.

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Macro Technical Analysis - Bianco Research