UPSIDE BREAKOUT IN BOND YIELD WEIGHS ON HOMEBUILDERS AND MAY THREATEN MARKET RALLY -- MARKET SELLS OFF ON HEAVY VOLUME -- NASDAQ CLOSES BELOW 50-DAY AVERAGE

BOND YIELDS REACH FIVE-MONTH HIGH ... The upturn in bond yields that started during December is starting to look more serious. Chart 1 shows the 10-year T-note yield trading over its late October peak (4.85%) and its 200-day moving average for the first time since August. A decisive close over 4.85% would confirm that the intermediate trend of bond yields has turned higher and would reverse the drop in bond yields that started last July. Chart 2 shows a similar uptrend developing in the 30-year T-bond yield. If that upside breakout occurs, it carries implications for several markets. It would be bearish for bond prices, which drop when yields rise. It might stall the stock market advance which started last summer when bond yields started falling. And it may take a toll on one of the most rate-sensitive groups of all -- homebuilders.

Chart 1

Chart 2

HOUSING INDEX DROPS ... It may not be a concidence that the potential upside breakout in bond yields is occurring on the same day that housing stocks are dropping 2.3% and are one of the market's weakest groups. [They're weighing on the entire consumer discretionary sector which is also showing relative weakness]. Chart 3 shows that the PHLX Housing Index (HGX) bottomed last July and has been rising since then. The relative strength ratio (solid line) bottomed during November. Since then, homebuilders have been helping lead the rest of the market higher (thereby alleviating some concerns about the fallout from a weak housing sector). Although the housing uptrend is still intact, the 9-day RSI line in Chart 3 is showing "negative divergence" around the 70 level (see down arrow). That's the first time that's happened since the RSI bottomed last July. Charts 4 and 5 show two homebuilders that are also diverging from the housing uptrend. PHM (Chart 4) has failed three times to get above the 35 level. Chart 5 shows Centex trading well below its December peak. Those negative divergences suggest at the very least that the housing rally may be due for a setback.

Chart 3

Chart 4

Chart 5

RISING RATES HURT HOMEBUILDERS ... Chart 6 shows why an upside breakout in bond yields could be bad for homebuilders. It overlays the 10-year T-note yield (green line) on the Housing Index (bars) over the last two years. A clear inverse relationship between the two can be seen. Upturns in bond yields in the summer of 2005 and at the start of 2006 (green up arrows) coincided with downturns in housing stocks. Last summer's upturn in the housing stocks (purple up arrow) occurred as bond yields peaked. That inverse relationship makes it unlikely that the housing rally can continue if bond yields continue to rise. Chart 7 shows the same relationship in a different way. Chart 7 overlays bond prices instead of yields. The chart shows that the 7-10 Year Lehman Bros. T-Bond ETF (green line) usually trends in the same direction as housing stocks. Turns in bond prices usually lead (or coincide with) similar turns in the housing index. Bond prices peaked before housing stocks at the start of 2006 (green down arrow). And they bottomed before housing stocks last July (up arrow). Bond prices have been falling since December (yellow circle). If that drop continues, housing stocks are likely to follow suit. Falling bond prices (and rising yields) may also cause the stock market rally to stall. For one thing, it could remove the bullish prop provided by housing stocks. For another, the stock market rally since last summer has fed off lower rates.

Chart 6

Chart 7

RISING RATES POST THREAT TO MARKET ... Chart 8 shows that the decline in the 10-Year T-note yield (green line) that started last July helped launch the the rally in the S&P 500 that started the same month. Much of the drop in bond yields came from falling commodity prices and the belief that the Fed was ready to start lowering short-term rates. Recent signs of economic strength have virtually eliminated hope for Fed easing anytime soon. And oversold commodity markets are starting to bounce a bit. The stock market has managed to rally in the face of rising bond yields since December. Today's upside breakout in bond yields, however, is a bit more serious. That yellow flag may explain why stock investors are starting to take some profits.

Chart 8

HEAVY VOLUME SELLING ... Some short-term chart damage was done to the stock market today. Chart 9 shows the Nasdaq 100 Shares (QQQQ) closing back below its 50-day moving average (as did the Nasdaq Composite Index). And it did so on rising volume. That increases the odds for a retest of the recent lows. The S&P 500 SPDR (SPY) is still well above its 50-day line and its January low (Chart 10). But it too lost more than 1% today on rising volume. That increases the odds for a retest of its 50-day line. The market's uptrend in still intact. But today's upside breakout in bond yields -- combined with heavy selling in stocks -- raises the odds for a test of initial support levels.

Chart 9

Chart 10