INTERMARKET ANALYSIS
The Consumer Price Index With Food And Energy Prices, Or Without?
Which Inflation Rate?
by Alex Saitta and Yuxin Li
So you're going to use an inflation rate to gauge the market you're interested in. Which one are you going to use? Which one fits your needs?
Bond yields provide a fixed coupon or income. As the rate of inflation rises, the coupon's buying power declines; as the rate of inflation falls, more goods and services can be purchased with that fixed coupon. For this reason bond yields are strongly linked to the inflation rate, and the inflation rate is of paramount importance to bond investors.
FIGURE 1: YIELDS VS. INFLATION. As inflation declines, bond yields follow. The relationship can be tracked with correlation analysis.
Which inflation rate, though? When talking about inflation in the context of their bond forecasts, economists often note the trend of the Consumer Price Index (CPI) excluding food and energy prices (CPIXFAE). Laymen, though, still focus on the rate of the overall CPI. Is the relationship between the yield of the 30-year bond stronger with CPIXFAE or overall CPI?
To help answer that question, we did two tests. Correlation analysis measures the degree of association between two time series, and it produces a statistic called the correlation coefficient. The coefficient ranges from -1.0 to +1.0 and identifies the direction as well as the strength of a relationship between the two variables.
For example, a coefficient of +1.0 marks a perfect positive relationship. When one variable rises, the other rises in lockstep. When one falls, the other falls in unison. A coefficient between zero and +1.0 is a nonperfect positive relationship. In that case, when one variable rises, the other usually rises; when one falls, the other usually falls.
When the coefficient is less than zero, a negative or inverse relationship exists. A coefficient of zero indicates there is no relationship between the two variables; in such a case, when one variable changes, it is equally likely the other variable will rise or fall.
Alex Saitta is a technical analyst for Salomon Smith Barney and recently was named as top technical analyst by Institutional Investor's All-America Research Team for fixed income. Yuxin Li assists him.
Excerpted from an article originally published in the November 2000 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2000, Technical Analysis, Inc.
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