MAJOR BULL MARKET IN BONDS MAY BE ENDING -- WHAT THAT MEANS FOR STOCKS -- JAPAN MAY HOLD KEY TO US BOND YIELDS

TWENTY-FIVE YEAR BOND BULL MAY BE ENDING... Bill Gross stated last week that he had turned bearish on bond prices for the first time in more than twenty years. Given that he runs the world's biggest bond fund at Pimco, I thought I'd show you why he may be right. Chart 1 plots price of the 30-year T-Bond since it bottomed in 1981. Bond prices have been on a major bull market for the twenty-six years since then. But that may be about to end. Bond prices are now threatening their long-term trendline. In addition, bond prices are dangerously close to breaking support levels (previous lows) for the first time in more than two decades. That danger can be seen more close in Chart 2. Bond prices peaked in 2003 and have been trading sideways since then. A drop below the 2006 low near 105 would not only break an important support level, it would also break the twenty-six year support line.

Chart 1

Chart 2

THAT MEANS YIELDS ARE RISING ... When bond prices fall, yields rise. The next chart shows the 10-Year Treasury Note Yield which is close to being a mirror image of bond prices in Chart 2. The key level to watch in Chart 4 is the peak formed in the spring of 2006 near 5.25%. A decisive close above that level would continue the pattern of rising peaks and troughs that started in 2003 and would put bond yields at the highest level in five years. The major significance of an upside breakout in bond yields is seen in Chart 4. A close over 5.25% would break a down trendline in bond yields connecting the highs of 1994 and 2000. That trendline spans thirteen years. An upside penetration of that trendline would leave little doubt that the period of low rates has ended.

Chart 3

Chart 4

BOND PRICES ARE LEADING INDICATOR FOR STOCKS.... One of the principles of intermarket analysis is that bond prices act as leading indicators for stocks. In other words, bond prices peak and trough ahead of the stock market. Take a look at the comparison of bond prices (price bars) and the S&P 500 (solid line) during the 1980s. Bond prices bottomed in 1981. Stocks bottomed one year later in 1982. Two stock bear markets occurred in the ten years following that bottom -- in 1987 and 1990. In both cases, bond prices peaked several months earlier (green arrows).

Chart 5

BONDS PEAKED BEFORE STOCKS IN 1998 ... Chart 6 compares bond and stock prices over the last ten years. The chart shows that bond prices peaked in 1998, which was more than a year before stocks peaked in 2000. The jump in rates during 1999 was one of the factors leading to the stock market drop in 2000. Bond prices rose throughout the three-year bear market in stocks lasting from 2000 to the end of 2002. [That was largely due to aggressive Fed easing due to fears of deflation. During deflation, bond prices rise while stocks fall]. Which brings us to the present. Bond prices peaked in 2003 as stocks bottomed. That was the result of asset switching out of bonds and back into stocks. Since then, bond prices have just treaded water as stocks have continued to rise. Two things on the chart worry me at the moment. One is a potential breakdown in bond prices. The other is the fact that the S&P 500 (red line) is testing potential resistance at its 2000 high. Falling bond prices (rising bond yields) may not be an immediate threat to the stock market. However, a significant breakdown in bond prices (upside breakout in yields) would suggest that the bull market in stocks has entered a more dangerous stage.

Chart 6

JAPAN HOLDS KEY TO INTEREST RATES ... I believe that one of the factors keeping global rates relatively low has been the weakness of Japan. That weakness has been largely the result of a deflationary problem which is just now showing signs of dissipating. [The threat of Asian deflation after 1998 was one of the factors driving global bond yields to historically low levels]. The relative weakness of Japan (and rates near 1%) has acted as a weight on global yields since then. Today's announcement that Japan's GDP was revised up to 3.3% makes its economy potentially stronger than the U.S. or Europe. That increases the odds for higher Japanese bond yields. Which in turn increases the odds for higher U.S. bond yields. That suggests to me that Japan may hold one of the keys to the upward revision in global interest rates. Charts 7 and 8 show a similarilty between Japanese stocks (Chart 8) and U.S. bond yields (Chart 9). To make the point more graphically, Chart 9 overlays the Nikkei 225 (orange line) and the yield on the 10-Year T-Note yield since 1989. It looks to me like the two lines have been closely correlated for the last 20 years. A falling Japan from 1990 to 2003 acted as a depressant on U.S. bond yields. A rising Japan is now having the opposite effect.

Chart 7

Chart 8

Chart 9