BOND/STOCK RATIO IS STILL IN UPTREND -- THE LONG BOND, HOWEVER, IS STARTING TO LAG BEHIND SHORTER MATURITIES AS INFLATION RISES AND YIELD CURVE STEEPENS -- TIPS OFFER A WAY TO SHORTEN BOND MATURITY WHILE OFFERING INFLATION PROTECTION

BONDS ARE STILL ACTING BETTER THAN STOCKS... Last Friday I wrote about the different bond ETFs available to investors. I finished up with a few conclusions. One was that bonds are still a preferred investment over stocks. That's usually the case in the early stages of an economic slowdown. That doesn't mean that bonds are a great investment. It just means that they're doing better than stocks. Chart 1 plots the 7-10-Year T-Bond ETF (blue line) relative to the S&P 500 (black line) over the last year. The rotation out of stocks and into bonds started last July when subprime problems surfaced and stocks began a topping process. One reader suggested that bonds were a bad place to be because they don't offer a lot of upside potential. With yields so low, that may be true. But, at the moment, the bond/stock ratio is still rising.

Chart 1

BONDS UNDERPERFORM COMMODITIES ... Historically, it's unusual to see bond prices rising along with commodities. But that's what's been happening since last July owing to stock and economic weakness followed by aggressive Fed easing. That has lowered rates (pushing bond prices higher). It's also weakened the dollar pushing commodities higher. Although bonds and commodities have been the two strongest asset classes since midyear, commodities have been the stronger of the two. Chart 2 compares the 7-10 Year Bond ETF (blue line) to the CRB Index (flat black line) over the last year. After a burst of bond buying during July and August, bond prices have lagged behind commodity prices by -19%. That means that while bonds are acting better than stocks, they're lagging way behind commodities. From a longer-range perspective, that puts bonds in a precarious position. They'll probably continue to outperform stocks until the stock market and the economy bottom out. Bonds, however, may suffer further down the line if the Fed needs to raise rates to combat inflation. That makes bonds a reasonable choice for the moment, but not over the long run.

Chart 2

YIELD CURVE AND COMMODITIES ARE LINKED... I drew a couple of other conclusions last week. One was that the long bond was starting to underperform shorter maturities which suggested that investors should move to the shorter part of the yield curve. That's because the long bond will lag behind shorter maturities as inflation pressures mount. And the fact that commodity prices are trading at record highs suggests that will happen. Another factor working against the long bond is the steepening of the yield curve. That occurs when short-term rates fall faster than long-term rates (as the Fed lowers short-term rates to help the economy). But there's another factor to consider and that's the impact of inflation. Chart 5 plots the CRB Index (red line) and the 10-Year T-Bond yield (blue line) relative to the 2-Year T-Bond yield (flat black line). [In other words, we're comparing the direction of the yield curve to the direction of commodities]. Notice the strong correlation between the two lines. The chart suggests that a steepening yield curve is normally associated with rising commodity prices. There are two reasons for that. A steepening yield curve weakens the dollar which pushes commodity prices higher. Rising commodities, in turn, cause the yield spread to steepen. Since bond prices trend in the opposite direction of yields, a steepening yield curve favors investments in shorter maturities in a climate of rising inflation. It also favors some exposure to Treasury Inflation Protected Securities (TIPS).

Chart 3

COMMODITY HIGH FAVORS SHORTER MATURITIES... Instead of bond yields, Chart 4 compares the prices of two T-Bond ETFs of different maturities. The reddish line is a ratio of the 10-Year Yield (IEF) to the 20 Year Bond Yield (TLT). The green line is the CRB Index. Except for the period from last August through November, a close correlation exists between the two lines. When commodities fell during most of 2006, the longer maturity did better than the shorter one (the ratio fell). When commodities rose during the first half of 2007, the shorter maturity did better (the ratio rose). But what about the period since last August when longer maturities did better as commodities rose? Here's my take on that. In the early stages of the stock market downturn, it was believed by the Fed that a coming recession would slow inflation. That pushed money fleeing stocks into the long bond. During January, however, the CRB Index hit a new record high and re-awakened inflation fears. That may explain why shorter-maturities started to outperform longer maturities (a rising ratio) at the same time. In other words, investors stayed in bonds. They just started moving to shorter bond maturities.

Chart 4

YOU CAN SHORTEN MATURITIES WITH TIPS... Last Friday, I plotted a ratio of the Treasury Inflation Protected Bond ETF (TIP) divided by the 20 Year Bond ETF (TLT) to show that money was starting to flow out of the long bond into TIPS to protect against rising inflation pressures in the form of record commodity prices. Chart 5 is another version of the same ratio and shows that process beginning last December and accelerating during January. In addition to the inflation protection TIPS offer, you also get the benefit of shorter maturities. Although TIP maturities range from one to 25 years, its biggest concentration ranges from 5-10 years (39%) to 1-5 years (31%). That puts 70% of its bonds with maturities of less than 10 years. A couple of Inflation-Protected mutual funds I checked put maturities in the 8-9 year range. Chart 6 shows one of them. TIPS offer a way to hold shorter-maturity bonds with some protection against inflation either through a mutual fund or an Exchange Traded Fund.

Chart 5

Chart 6