While the bond market’s day-to-day fluctuations usually aren’t a priority for most investors, those who own stocks in the beaten-down segments of the materials sector should be paying rapt attention to the 10-year Treasury note.
Why? The picture below tells the story.
This chart shows the yield of the 10-year note (TNX) compared to three industry groupings — coal, steel and aluminum — and the results are remarkable. During the past two years, these segments have exhibited an extraordinarily tight relationship to the 10-year yield … and that might provide an indication of how to trade these sectors in the months ahead.
Alcoa vs. Treasuries: What’s the Difference?
Among the three groups, aluminum stocks have matched the moves in the 10-year on almost a day-for-day basis. The Dow Jones Aluminum Index is dominated by Alcoa (NYSE:AA), but it also contains smaller yet familiar stocks such as Aluminum Corp. of China (NYSE:ACH), Alumina (NYSE:AWC) and Kaiser Aluminum (NASDAQ:KALU). From a look at the chart above, it’s evident that the index has been almost perfectly correlated with the 10-year yield in the past two years.
This always has been the case to some extent, but the trend has been much more prevalent in recent years. This is most visible in Alcoa, which has a correlation of 0.98 with the 10-year Treasury since the beginning of 2011 — about as close to perfect as you’ll ever see:
The other groups aren’t far behind, however. The Market Vectors Steel Index Fund (NYSE:SLX), whose largest holdings are Rio Tinto (NYSE:RIO) and Vale (NYSE:VALE), checks in with a correlation of 0.97. The Market Vectors-Coal ETF (NYSE:KOL), which features Consol Energy (NYSE:CNX) as its largest holding, is at 0.93. Keep in mind, 1.0 is as high as correlations can go.
Why Does This Matter?
For the past two years, the tight relationship with Treasury yields has been a bad thing for investors in these downtrodden sectors. But now, that might be about to change. On Thursday, the 10-year closed Thursday above its 200-day moving average after moving from 1.66% to 1.83% in the past eight sessions.
This isn’t the first time such a breach has occurred — Treasuries also provided a similar head-fake in March and again last month. And on Friday, yields backed off from their highs for the week. Still, three key elements of the 10-year Treasury note’s technical picture have changed this time:
- The 200-day moving average, after falling for more than a year, has begun to turn upward.
- It has put in a series of higher lows for three months — something that hasn’t occurred since late 2010.
- Perhaps most notably, a continued uptrend will bring about a “golden cross,” or a move in the 50-day moving average above the 200-day. The last time the 50 was higher than the 200 was back in July of 2011. The 30-year bond (TYX) is much closer to achieving this milestone; it will take only a few more weeks of rising yields for the golden cross to occur.
If the 10-year yield can hold above its 200-day, it could mark a turning point for coal, steel and aluminum. Already, these sectors are beginning to show signs of life amid stronger U.S. economic data and evidence of stabilization in China’s economy. If Treasuries finally begin to sell off, it all comes together for these sectors: economic fundamentals, valuations and technicals will all be in line to set up a substantial rally.
Will this happen? Much of it depends on the impact that the election and subsequent discussions surrounding the fiscal cliff have on the bond market. But for now, don’t take your eyes off of the Treasury market — it could well provide the green light to make the move into cyclicals.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.