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Wilkinson's Wedge MoneyNews
Dear MoneyNews Reader, After mentioning it last week, I had a phenomenal response from many of you interested in learning more about our soon-to-be-launched "hedge fund" service. Once the planning process moves farther along, I'll send you more information on how the program is designed to work. In today's column, I turn my attention toward a couple of likely candidates that will undoubtedly feature in the service over the course of 2006, as I take a look at prices for copper and government bonds.
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If you would like to be added to this limited-invitation VIP list and you haven't already dropped me a line, here's the e-mail address once again. This way you can be sure that you will receive one of the very first invites. Membership will be on a "first come, first served" basis, so if you think this type of service may be appropriate for you, please let me know right away by sending me an e-mail via the link below. German Government Bond Bears This week the European Central Bank raised its benchmark interest rate one-quarter point to 2.5%. But traders were hardly taken aback by the move. It had been widely anticipated since for months now, various ECB spokesmen have been hinting strongly about the impending action. The start of the European rate-raising cycle began with a similar rise in December. Since this was not a surprise to traders, the German benchmark bonds' reaction to the move was a little surprising. Bonds are sensitive to inflation since their fixed coupon payment is eroded by rising prices. With inflationary pressures muted globally, bond prices worldwide have been well supported by buyers looking for secure top-quality government debt. Germany, the largest Eurozone economy, is the benchmark for local bond trading.
In response to the rate rise this week, traders sent bond prices reeling and added six basis points to the 10-year yield. Rates rose to 3.56%, which is 107 basis points (1.07%) below the equivalent U.S. treasury 10-year note at 4.63%. What caught my eye as traders turned the screen prices red was that bonds broke through key support on the chart. To me this was an important move because it has implications for other bond yields, including those in North America. We've grown accustomed to the Fed raising rates, yet mortgage rates remain anchored precisely because investors have faith that inflation remains under control. The down leg in bond prices this week was evident across most markets as bond traders sold bonds globally. British gilt yields rose 8 basis points to 4.24% on the week, while Australian yields jumped from 5.21% to 5.28%. Canada's government benchmark rose 6 basis points to 4.21% while French yields added 8 basis points to 3.60%. But the technical chart formation tells me that the move isn't over yet. German bonds formed what in technical jargon is known as a "bearish wedge." Take a look at the chart drawn on my handy-dandy Bloomberg terminal and I'll try to talk you through why I believe that if you haven't yet fixed your mortgage, now might be a good time to do so.
In mid-November, bond prices formed a bottom after a two-month sell-off. During the following three months, prices ascended - and as you can see, the range in which they bounced around narrowed, creating a "wedge" formation. With any technical pattern comes a defined measurable objective. There are two types of wedges and each runs counter to the ultimate objective. When prices rise in a wedge formation, traders are looking for a breakout of the formation against the shorter-term trend. So the break below the lower-wedge trend line in mid-January predicted a specific objective. Wedges are powerful formations. Their objectives call for fresh contract highs and lows. In this case, the rising wedge when broken calls for a fresh contract low. That January break signaled that perhaps a new powerful trend was in place and that investors should position themselves for rising bond yields. I added two key horizontal lines on this chart. The lower one denotes the turning point in November, marking the contract low. The second - and more recent - line marks the break of support this week, which indicates consolidation on the charts. Well, that got blown out of the water this week as yields rose while bond prices slid. In the German case we are getting pretty close to the November low. And it's an identical picture for 10-year U.S. Treasury prices. But remember this: The bearish wedge formation calls for a fresh contract low as a MINIMUM price objective. I wouldn't rush in to buy bonds if we do achieve the target. The move might have some way to run below the target. Bear season may just have started in the bond market after a period of hibernation. I'm still hanging my hat on seeing that 4.75-5% window opening up. Editor's Note:
Commodities Corner On the one hand, the supply situation is still so tight that global stockpiles are still only sufficient for several days worth of consumption. Earlier this week, a major pillar of support was taken away from the copper market when data on sales of both new and existing homes once again showed a decisive slowdown in the U.S. housing market. Copper is used in plumbing and electrical wiring, and its demand is clearly tied to the demand for new homes. Bad news for the homebuilders feeds through to copper miners. In the first two months of the year, inventories held in London's copper warehouses have increased by almost 25%. In part that explains why the price of copper has put in a peak this year. However, it's difficult to accurately determine a top to the market. But later in the week, I noted several more optimistic comments from analysts regarding the outlook for the metal. Mexico's two largest mines saw local workers walk off the job and strike, further harming an already tight supply. Supply concerns have shifted the supply/demand balance for this year and the next. At one point, experts thought that supply would outweigh demand throughout 2006 and 2007. The nationwide strike in Mexico sent the price of copper futures sharply higher during midweek trading. When several conflicting pieces of information come to light, it is often helpful to turn to a more detailed examination of open interest. I mentioned the same point last week as I examined the price of gold. A look at data from the Commodities and Futures Trading Commission (CFTC) can be quite revealing. This agency tracks the size of open positions held by traders on futures exchanges. Each trader is assigned one of two titles - either "commercial" (end-users of a specific commodity) or "non-commercial" (speculators). Each long or short futures trade is matched, since for every buyer there MUST be a seller. All open positions are added together and referred to as open interest. Trends are established as more traders build positions - and a key gauge of this activity is the open interest. Trends build a head of steam when more money pours into the market and new bets are made. Since speculators play a pivotal role in developing the strength of any trend, investors keep a keen eye on the level of speculative positions in futures markets. So last week's news that speculators have now gone net short of copper futures was quite a shocker. Take a look at the chart. It could be argued that the last $60 in the rise of copper is purely froth. Admittedly, that froth has developed over an entire year, but it's quite clear that the move from between $120 and $170 in copper saw a huge build in speculative longs.
Since June 2005, those longs have sold their copper futures despite the continued rally to around $230 per pound for the metal. In late February the number of speculative shorts outweighed those who believe that copper will continue to rise. So on the one hand, we have a market constrained by both the volume of metal that can be mined from the ground and the development of new mining facilities. The rising price of just about all products ultimately deters buyers. Chinese imports of copper declined by 36% in January, according to government data. But we have to be careful about how we piece all of this together, since rising prices can also cause traders short of their positions to cover those shorts and BUY them back. That simply fuels even higher prices. But there's another clue that might lead a speculator to short the copper market. A futures market allows producers and speculators to hedge their risk over the course of time. That's why they are so-called "futures markets." Try to imagine a series of copper prices across a span of time that would allow you to lock in a price today that you expect to be happy with in the future. One trick of the trade for savvy speculators is to buy a far-dated futures contract at a lower price than the prevailing "spot" market. That's the market for immediate delivery. If prices do hold up over time, speculators can expect to profit from their longer-dated bets catching up with the spot price. The far future rises in value as it becomes the spot contract. Check out the following chart, which depicts the 12-month spread between the spot contract and the contract expiring twelve months into the future.
The chart is showing us that the spot month is consistently higher than the one-year forward price. Between August and December, that spread roared as the spot market surged in the face of heavy fundamental demand and ongoing labor-related disruptions. But since then, the price of copper has still risen by 6.5%. However, the spread between the spot and one-year forward prices has evaporated. As speculators are turning tail and the spread is disappearing, this could mean there will be no copper bull market anytime soon. Have a great week!
Andrew Wilkinson P.S. Warren Buffett is so convinced we'll see a steady downward spiral to the value of the dollar in 2006, he's placed a $16.5 billion dollar bet to back it up. Discover how to cash in on his big bet now in our FREE MoneyNews special report. Go here now.
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Wilkinson's Edge
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