I generally try to keep my blogs both instructive and useable in the short run.? Today?s takes a bit longer view of our markets.??

As you may know, I am ?big? on correlations.? When macro level events occur, they do not occur in a vacuum.? And, their affects are often wide reaching and somewhat predictable.? Though there is no ?certainty? to this cause and effect relationship, I believe an understanding of typical correlations can improve the odds in my trading.? After all, ALL trades are nothing more than a probability game where we hope to turn the odds in our favor.? Why these ramblings today?? I have been watching the correlation between oil and bonds for the last year with some interest.? Why?

Perhaps above any other single instrument, oil prices may have the most affect on inflation. ?Oil is not only used for heating and transportation, it is also used in the manufacturing process for many products.? As such, when oil prices rise considerably, we often see inflation pick up.? With our current interest rates so low, a large spike in oil prices could be problematic for our bond prices as inflation causes higher rates, which in turn cause lower bond prices.? This means that oil and bonds should be inversely correlated.? Logical, right?? Let?s take a look at their correlation and see if this plays out in the market.? Here are the results of a quick correlation study I put together.? (If you are unclear how to do a correlation study, please see the ?Al on Video? section of my website.)? This is the correlation between oil prices and bond prices over various time frames.? ?

8 yr ? ?-56.88%

5 yr ? ?-48.87%

3 yr ? ?-41.63%

1 yr ? ??18.36%

6 mo ? ?76.42%

3 mo ? ?72.10%

As you can see, in the longer term, the products are inversely correlated as we predicted.? But, in the past year, this correlation has not only broken down, but reversed!? Why?? I can only guess at the reasons, and here is my best guess.

The Fed has been holding interest rates low for a long period of time.? This has kept bond prices (artificially?) high regardless of what the rest of the market is doing.? This could easily ?un-correlate? the two products as the pricing of the two products are being driven by different forces.? And, over this same period of time, oil is up almost 14%.? So, the products appear to be positively correlated.

You may be asking, ?interesting, but, so what??? As traders like to say, no one party is bigger than the market.? That includes our government.? If oil continues its upward trend, as we are seeing with the unfortunate events occurring in Iraq at present, I believe this inflationary pressure will find its way into the bond market and our inverse correlation should return.? Reiterating the statement that nothing occurs in a vacuum, weakness in our economy, housing market and employment situation could prove to counteract some of the effects of high oil prices on inflation going forward.? So, I am watching all these catalysts and lining up a correlation play in the future. ?What play?? Depends on too many things to venture a guess now.? But, when I see it, I will blog again and that blog will be timelier than these musings. ? ?