Investors trying to divine the next move in certain cyclical stocks may need to look no further than the 10-year Treasury note. The correlation between the chart pattern of the 10-year yield and that of the aluminum, coal, nonferrous metals, and steel sectors has been at an extraordinarily high level in the past year. This indicates that the ability of these four sectors to sustain their recent rally may require confirmation from the 10-year. So far, that isn’t happening — which may be a negative sign for stocks in these groups.
The three charts below show the extent of the connection between the benchmark T-note and the performance of aluminum, coal, and nonferrous metals.
Dow Jones U.S. Aluminum Index (DJUSAL)
Dow Jones U.S. Coal Index (DJUSCL)
Dow Jones U.S. Nonferrous Metals Index (DJUSNF)
Steel also has shown a high correlation with the 10-year yield during the past 12 months, but it has experienced a stronger positive divergence of late.
Dow Jones U.S. Steel Index (DJUSST)
It stands to reason that the 10-year yield would track the stock prices of cyclicals since stronger economic growth is a catalyst to drive both higher. Indeed, a look at the longer-term charts on the sectors discussed here shows that while there have been periods of divergence, all tend to follow longer-term Treasury yields fairly closely over time. The tight correlation of the past year could be expected at a time in which macroeconomic concerns have been the primary driver of asset prices, but investors can nevertheless use the connection between bonds and cyclicals to their advantage in two ways:
First, the fact that the 10-year yield has held stubbornly under 2% thus far in 2012 serves as a potential warning for short-term investors since steel, aluminum, nonferrous metals, and coal have all provided investors with stellar returns year-to-date. If there isn’t a confirmation from the 10-year soon, it may be an indication that the recent move in these four sectors is just a head fake. We may be nearing the point where something has to give since Tuesday and Wednesday brought robust performance for the four sectors even as the 10-year fell from 1.96% to 1.90%.
Second, a convincing move above 2% would be a very bullish sign for these market segments — with “convincing” being the operative, and problematic, word. Since falling under 2% in early September, the 10-year has made no fewer than eight attempts to pass this key level, and it has failed on each occasion. On one of these attempts, the 10-year spent virtually the entire month of October above 2% before failing on the first day of November. The takeaway: This is an indicator that can produce some confusing signals. Still, it’s clear from the charts above that government bonds should be a primary focus for anyone who is considering a trade in these four sectors.
Below are some of the stocks in each sector that have an above-average correlation with the 10-year Treasury note:
Aluminum Corp. of China (NYSE:ACH)
Century Aluminum (NASDAQ:CENX)
Peabody Energy (NYSE:BTU)
Walter Energy (NYSE:WLT)
Arch Coal (NYSE:ACI)
Freeport-McMoRan Copper & Gold (NYSE:FCX)
Teck Resources Ltd. (NYSE:TCK)
Arcelor Mittal (NYSE:MT)
U.S. Steel (NYSE:X)
Steel Dynamics (NYSE:STLD)
AK Steel (NYSE:AKS)