V.14:1 (11-18): The Electric Utility Bond Market Indicator by Dennis Meyers, Ph.D.
There's a close relationship between the performance of the electric utilities stock index and the bond market. Technicians use this relationship to forecast the direction of interest rates. This S&C Contributing Editor takes it one step further and designs a trading system for bonds based on the S&P 500 electric utility index.
Electric utilities stock indices have long been assumed to be a leading indicator of the bond market. Utilities are linked to bonds, the theory goes, because they are influenced by the direction of long-term interest rates. The economic reasoning for the links and influences between the utility stock indices and long-term interest rates have never been satisfactorily developed. However, stocks seem to lead the economic statistics that have a direct bearing on the economy.
Most of the published work on the utilities-interest rate relationship to date has been anecdotal; graphs and charts of the bonds and electric utilities have been used by various analysts, and the lead-lag relationship between the two indices over a few select periods has been frequently noted. No concerted effort has been made, however, to determine an exact formula or equation that would allow predicting the direction of one index from the other.
I will do so here. I will create and test various technical indicators on the electric utility index in an attempt to predict the direction of long-term interest rates.
Choosing the long-term interest rate series deserves discussion. Many analysts tend to use the Dow Jones 20 bond (DJ20) index as a proxy for the bond market. What is not commonly known is that prior to 1994, a few of the components of the DJ20 were convertible bonds. Convertible bonds act like stock when the price of the underlying stock is above the conversion price. This point was hammered home on December 6, 1993, when one of the components of the DJ20, the Hercules 8% 2010 convertible bond, jumped 43 points in one day because of a takeover play on the underlying stock.
This caused the DJ20 to rise by 2.11 points, even though the bond market itself was quiet that day. Dow Jones replaced the Hercules bond with another true bond series and adjusted the DJ20 series for the jump. The point remains, however, that the DJ20 was not a pure bond index, and so it will not be used here. Without the DJ20, there are few choices left if accurate data going back over 20 years is required.
For long-term interest rates, I will use the daily 30-year Treasury bond yield series. This series is widely available, and historical data can be obtained from the St. Louis Federal Reserve Board via their free electronic bulletin board service and through popular data services. A weekly 30-year T-bond yield series will be created from the daily series. For the electric utility index, the weekly S&P electric utility index (EUT) will be used. The EUT is published every Wednesday by Standard & Poor's and is released on that day after the close. (For definitions on the parameters used in this article, see sidebar, "Defining parameters.")