A STRONG GERMANY IS PUSHING GLOBAL BOND YIELDS HIGHER AND BOOSTS EURO -- A WEAKER DOLLAR PUSHES GOLD TO A 25-YER HIGH -- EWJ BREAKS OUT -- SMALL CAP LEADERSHIP IS A SIGN OF MARKET OPTIMISM

GERMANY LEADS STRONG EUROPEAN GAINS ... A lot of today's intermarket moves can be traced to new signs of strength in Europe. Today, for example, three of Europe's markets -- France, Germany, and Italy -- showed gains of more than 1% to lead global markets higher. The biggest of the three -- Germany -- is trading at a new five year high. In fact, European markets have been rising faster than the U.S. for the last year. That's important for a number of reasons. For one, it makes Europe a good alternative for global funds. Secondly, strong economic news out of Germany boosted German bund rates earlier in the week and is helping to push U.S. bond yields higher. Thirdly, a stronger Europe makes it more likely for the ECB to start raising European short-term rates more aggressively. That explains why the Euro is strong today while the dollar is weakening. Chart 1 shows the German DAX closing at the highest level since the middle of 2001. Its relative strength ratio is rising faster than the S&P 500. Germany iShares have been even stronger as shown in Chart 2. The stronger performance by the EWG is due to new signs of strength in the European currency as shown in Chart 3. The Euro has climbed back over its 200-day moving average and appears to be bottoming. A rising Euro makes the EWG act stronger than the DAX. In other words, the EWG benefits from rising German stocks and a rising Euro.

Chart 1

Chart 2

Chart 3

WEAKER DOLLAR PUSHES GOLD TO NEW 25-YEAR HIGH -- EWJ BREAKS OUT WITH GOLD ... One of the side-effects of a rising Euro is a falling dollar. A falling dollar is bullish for gold and most other commodities. That helps explain why silver is trading at a new 23-year high and gold at a 25-year high. It also explains why money is pouring into precious and industrial metal stocks tied to aluminum, copper, gold, silver, and steel. I recently suggested that rising gold prices were tied to a rising Japanese market since the world's second largest economy was moving out of a deflation. Charts 4 and 5 show the Gold ETF (GLD) and Japanese iShares (EWJ) hitting new highs together today. [The Nikkei 225 closed over 17,000 for the first time since 2000]. I also suggested that would boost global inflation pressures and eventually push global interest rates higher. That's happening.

Chart 4

Chart 5

10-YEAR T-NOTES NEAR 2004 PEAK ... With a lot of lift from global bond yields (especially in Germany and Japan), U.S. bond yields are nearing another crucial test. The weekly bars in Chart 6 show the 10-year Treasury note yield trading at 4.85% which is the highest level in nearly two years. More importantly, the TNX is nearing a challenge of the spring 2004 rate peak at 4.90%. Needless to say, a decisive close above that barrier (which appears likely) would leave little doubt that U.S. bond yields have finally embarked on a new uptrend. That's bearish for bonds since bond prices fall when bond yields rise. It's also potentially negative for interest-rate sensitive stock groups like financials, housing, and utilities. It may seem surprising to see the dollar weaken with U.S. rates rising. The problem is that foreign bond yields may be rising faster than U.S. yields -- or the market is expecting that to happen. If that happens, and the dollar continues to weaken, foreign markets will become even more attractive alternatives. So will commodity-related assets that feed off a weak dollar.

Chart 6

SPEAKING IN FLORIDA ... I'm heading out later today to Ft. Lauderdale to speak at a Forex Trading Expo. My topic is "The Role of Currency Markets in Global Intermarket Relationships". My main themes are the same ones outlined above and in several recent market messages. Namely, that a weaker dollar should continue to boost commodity prices and increase global inflation pressures. That should result in rising global interest rates as stronger economies give foreign central banks more room to raise rates to combat that inflation. Foreign ETFs should continue to benefit from a weaker dollar as well. That could hurt interest-rate shares, but should boost commodity-related stocks. My last slide carries the phase "moving from Asian deflation to Asian inflation". Asian deflation started with Japan in 1998. Chinese buying has been a big contributor to commodity-price inflation over the past few years. With Japan deflation ending, however, upward pressure on global interest rates should start to intensify. Markets like gold are rising in virtually all currency denominations. That means that global investors would rather own gold than currencies.

SMALL CAPS AND AD LINE ARE STILL RISING ... Rising interest rates can help the stock market over the short- to intermediate-term because it implies economic strength. It also causes some money to rotate out of falling bond prices and into stocks. Although rising bond yields usually cause problems for the market eventually, we have to watch the market indexes and certain technical indicators to spot when that's happening. One of those is the NYSE Advance-Decline line as shown in Chart 7. As of right now, the AD line is still rising. Historically, the AD line has peaked either before the market or coincident with it. The fact that it's still rising tells us the market's uptrend is still intact. And it will remain intact as long as the NYSE AD line stays over its 50- and 200-day moving averages. Another sign of strength is coming from small cap stocks. Chart 8 shows a ratio of the Russell 2000 Small Cap Index divided by the Russell 1000 Large Cap Index. The ratio has just broken out to a new high. That shows continued leadership in small caps. One of the usual early signs of a market top is underperformance by riskier small caps as money rotates to the relative safety of larger issues. That may happen during the second half of the year -- and I suspect it will -- but it hasn't happened yet. In reality, Charts 7 and 8 are linked. There's a correlation between the direction of small cap stocks and the AD line. That's because there are more small stocks than larger ones. Weakness in small stocks is usually one of the main reasons that the advance-decline line starts to weaken. Right now, small cap strength is helping keep the AD line in an uptrend.

Chart 7

Chart 8