AN UPTURN IN BOND YIELDS WOULD THREATEN HOUSING BOOM -- HOUSING INDEX IS STILL RISING BUT LOOKS OVER-EXTENDED

BOND YIELDS HAVE FLATTENED OUT ... Bond yields have been dropping since the early 1980's when the inflationary bubble of the 1970's ended. Chart 1 shows that portion of the drop in bond yields that started in early 2000. That drop was largely due to deflationary forces coming from Asia (mainly Japan) that pushed long-term rates to the lowest level in fifty years. The drop in bond yields from 2000 to the end of 2002 was accompanied by falling stocks prices which usually happens when deflation is a threat. In other words, bond prices rose while stock prices fell. Two of the side-effects of falling U.S. rates were a sharp drop in the U.S. Dollar and a boom in commodity prices. Normally that combination would have pushed bond yields higher by now. The fact that it hasn't has caused a lot of head-scratching in the financial world and the Fed. Chart 1 shows, however, that bond yields have been trading in a flat trading range for the last year after breaking a four-year down trendline. One of the basic tenets of chart analysis is that a downtrend is usually followed by a flat trend which is usually part of a bottoming process. It's hard to predict when that sideways trend will turn into an uptrend. Since the bottoming process has lasted two years (and short-term rates have been rising for more than a year), any sign of an upturn in bond yields needs to be watched closely.

Chart 1

BOND YIELDS RISE TO TWO-MONTH HIGH ... Chart 2 shows the trend of the 10-year T-note yield since the start of 2005. After an upward spurt during February and March, yields fell briefly below 4% during June. Since June, however, the TNX has been rising. Nothing major yet. But enough to warrant closer attention. The TNX has risen above its June peak to turn its short-term trend higher. And it's moved back above the 200-day moving average. A large part of last week's jump came with the 2% revaluation in the Chinese yuan. Yesterday I showed that a bounce in bond yields usually leads to selling in rate-sensitive financial shares. Another group that's especially sensitive to the trend in long-term rates is anything tied to housing. The current housing boom has been based on historically low interest rates. The continuation of the current housing boom is largely dependent on the 10-year T-note yield shown in Chart 2 staying low. That's the yield that determines which way mortgage rates go. Any serious upturn in the TNX could threaten the housing sector.

Chart 2

COMPARISON OF RATES AND HOUSING ... Chart 3 compares the 10-year T-note yield (solid line) to Centex (monthly bars) for the last ten years. A clear inverse relationship is seen throughout those ten years. Falling bond yields from 1996 to 1998 pushed housing stocks higher. A 1999 bounce in yields pushed housing stocks lower. The major upturn in Centex took place at the start of 2000 as bond yields began their descent to fifty-year lows. In my view, the fact that bond yields have stayed so low has helped prolong the housing boom and the bull market in Centex and other housing stocks. That bull market could be threatened when bond yields do finally turn up.

Chart 3

HOUSING INDEX LOOKS OVER-EXTENDED ... Chart 4 shows the strong rise in the PHLX Housing Index (HGX) since the start of 2005. The latest bull run started in mid-May. There aren't any clear signs of a market top. About all we can say at this point is that the Housing Index looks over-extended. Its RSI line is starting to weaken from overbought territory over 70. And its MACD lines may be getting ready to rollover. The bottom line shows Bollinger Band width. It's normally a sign of strength when band width is expanding. At the moment, the band width looks high and is starting to dip a bit. That's due to the fact that the upper and lower bands are beginning to contract. That's often a sign that a trend has come too far and is in need of a breather. This doesn't look like a good time to be putting new money into the housing sector. It may even be a good time to start taking some money out. That will be especially true if bond yields continue to rise.

Chart 4