Using Metals to Trade Bonds

Sometimes things in the financial markets are pretty obvious if one is willing to see them.  Despite all of the angst that has been exhausted since July of 2016 – when the S&P 500 Index broke out to a new all-time high – regarding the 2016 election, the economy, interest rates and the “ultimate” effect that all of it may have the stock market – the market has just kept chugging higher.  This is not to say that everything can’t reverse and quickly, it is simply to note that people tend to spend a lot of time looking at stuff that seems “obviously important” and end up getting led astray anyway.

Now imagine the stuff that happens under the surface that they miss completely.  Like for example, the fact that the ratio between the price of gold and the price of copper is useful in identifying the trend in interest rates.

No, seriously.

Gold/Copper Ratio versus 10-Yr Treasury Yields

*The blue line in Figure 1 below displays the ratio of the price of gold divided by the price of copper since 1982.

*The red line displays ticker TNX – an index that tracks the yield on 10-yr. treasury bonds.

Notice anything about these two lines?

Figure 1 – Blue line=Gold/Copper Ratio; Red line=10-year treasury yield %

The phrase that we “quantitative analyst types” use for this type of relationship is “inversely correlated”.  According to my version of Excel the correlation between these two lines is -0.79.  For reference, a reading of +1.00 means perfectly correlated and a reading of -1.00 means perfectly inversely correlated.

In plain English this simply means that your eyes are not deceiving you and that yes, there is a strong inverse correction between the gold/copper ratio and 10-yr. treasury yields.

OK, so this is all very interesting, but let’s get down to it.  Is there a way to profit from this?  Well, it appears so. Follow my logic (such as it is):

a) Bonds prices move inversely to yields (i.e., as yields rise bonds prices fall and vice versa).

b) Therefore, if the gold/copper ratio is inversely correlated to 10-yr. yields then the gold/copper ratio should be highly correlated to 10-yr. bond prices.

c) Therefore a rising gold/copper ratio should (in theory) be accompanied by rising 10-yr. bond prices and vice versa.

If this does not make sense, just do what I do: look at the pictures below.

(See also It’s Soon or Never for Bonds)

Using Gold/Copper to Trade Bonds

Before I launch into this, my compliance people are threatening to taser me again if I fail to mention the following: What follows is not a “trading system” that guarantees profits, nor am I recommending that anyone use the method described next to trade.  It is strictly a “though experiment” designed to enlighten people that there are a lot of ways to “play this game” we call trading.

Alright with all of that firmly in mind (and with all weapons reholstered) here goes.

A = Gold price divided by Copper price

B = 30-day simple moving average of A

C = 80-day simple moving moving average of A

D = (B – C);

In other words Variable D represents the 30-day moving average of the gold/copper ratio minus the 80-day moving average of the  gold/copper ratio.

Figure 2 displays the value for variable D above – i.e., the 30-day MA minus the 80-day MA.

Simply note that:

a) This value fluctuates above and below 0

b) Our underlying theory is that positive values for D should be bullish for bond prices and  negative values for D should be bearish for bond prices

Figure 2 – Gold/Copper Ratio (30-day EMA minus 80-day EMA)

Now let’s test the theory.

Trading Rules:

*Use a 1-day lag (i.e., a “buy signal” or “sell signal” issued at the close one day is acted upon at the close of trading on the next trading day).

*If Variable D is greater than or equal to 0 then hold 10-year treasury bonds

*If Variable D is less than 0 then DO NOT hold the 10-year treasury bond (an aggressive trader could consider a short position in 10-year treasury bonds)

For testing purposes we use the daily dollar value change for the nearest 10-year treasury bond futures contract traded at the CBOT (stock based traders can consider shares of the ETF ticker IEF that tracks the 10-year bond).

Figure 3 displays the growth of equity achieved by holding a long position in 10-year treasury futures depending on whether the gold/copper ratio (using the 30-day/80-day averages mentioned above) is positive (blue line) or negative (red line).

(See also January Barometer Flashes a ‘Buy’. Now What?)

For the record:

*From May 1982 into early May 2017 a long position in 10-year futures when the 30-day MA for gold/copper was above the 80-day MA generated a gain of $98,275.

*By contract a long position in 10-year futures when the 30-day MA for gold/copper was below the 80-day MA generated a loss of -$35,501.

*No allowances are included in these numbers for slippage or commissions. The purpose is simply to highlight the stark difference in 10-year bond performance during periods when this “system” is bullish versus bearish.

Summary

So is this the “be all, end all” of bond trading methods?  Not at all.  How future results might play out if and when we eventually transition into a bona fide “rising rate environment” is essentially impossible to know.

But the inverse nature of the relationship of gold/copper versus 10-year yield has persisted strongly for over 30 years, so it may prove to be a very useful tool going forward.

In any event, the real purpose of this piece is to remind you to not always stare at the “shiny object” that the financial price holds up each day, and to recognize the need to – and advantage of – looking at things in unique ways.

Jay Kaeppel

Disclaimer:  The data presented herein were obtained from various third-party sources.  While I believe the data to be reliable, no representation is made as to, and no responsibility, warranty or liability is accepted for the accuracy or completeness of such information.  The information, opinions and ideas expressed herein are for informational and educational purposes only and do not constitute and should not be construed as investment advice, an advertisement or offering of investment advisory services, or an offer to sell or a solicitation to buy any security.

— by Jay Kaeppel from Jay on The Markets

About the Author Jay Kaeppel

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