BOND YIELDS PREDICT FED POLICY -- CHEMICAL STOCKS AND PROFITS UNDER PRESSURE -- USO HOLDS THE GAP -- XLE FORMS TRIANGLE -- RUSSELL 2000 BREAKS SUPPORT -- SMALL-CAPS VERSUS LARGE-CAPS

FED LEAVES RATES UNCHANGED ... Today's Market Message was written by Arthur Hill. John Murphy will return tomorrow. - Editor

As widely expected, the Fed left the federal funds rate and the discount rate unchanged. Inflationary pressures were cited for the decision. Way back in August, the Fed began cutting rates with a 0.5% cut in the discount rate. With the final rate cut coming at the end of April, the Fed lowered rates for nine months. Even though the Fed may have officially changed its policy today, the bond market already priced in the changes. Chart 1 shows the 10-Year Note Yield ($TNX) bottoming in mid March and moving higher the last 3 and a half months. Rates were already moving higher when the Fed last cut rates on 30 April and rates continued moving higher into June. It looks like the bond market is paving the way for the Fed. Put another way, the bond market is already doing some of the Fed's work. The 10-Year Note Yield rose from 3.3% to 4.3% and is at its highest levels of the year. Bonds are clearly concerned about something. Unless the 10-Year Note Yield reverses this uptrend, the Fed's next move will be to raise rates.

Chart 1

CHEMICAL PRICES VERSUS STOCK PRICES... Chemical prices are rising, but two of the big chemical stocks are falling. Dow Chemical (DOW) recently announced that it would raise prices as much as 25% in July. But wait, there's more. This is on top of a June increase, which was as much as 20%. That's right. Dow Chemical raised prices in June and will again in July. The company cited increased costs from natural gas and oil. These are not small increases. Moreover, other companies will likely follow suit and these costs will likely be passed on to the consumer. This looks like a classic case of producer price inflation turning into consumer price inflation. On Chart 2, Dow Chemical (DOW) is down around 15% since mid May and closing in on its March lows. On Chart 3, Dupont (DD) is down over 10% from its April high and testing support from its March lows. Both stocks are underperforming the S&P 500. Judging from these two price charts, the market does not view these price increases favorably.

Chart 2

Chart 3

OIL REMAINS STUCK IN A CONSOLIDATION... The Fed, the bond market and the chemical companies are not getting any help from oil. Chart 4 shows the United States Oil Fund ETF (USO) surging above 110 with a big gap in early June. This gap held as the ETF consolidated over the last few weeks. The range since 6 June has been rather tight, but the bulls are in clear control as long as this gap holds. In fact, the pattern over the last few weeks looks like a flat flag. A break above the flag highs would signal a continuation higher. A move below the consolidation lows would argue for at least a pullback. However, the big trend is clearly up with lots of support around 98-102. This support zone stems from the rising 50-day moving average, the February trend line and the early June low. For now, the most we can expect is a pullback within a larger uptrend. Chart 5 shows the Energy SPDR (XLE) with a triangle consolidation over the last few weeks. Like USO, a break above triangle resistance signals a continuation higher, but a break below triangle support would argue for a pullback within a bigger uptrend.

Chart 4

Chart 5

RUSSELL 2000 BREAKS SUPPORT... On June 4, I wrote about relative strength in the Russell 2000 and small-caps. However, I qualified this stance with a chart showing the index at resistance from a retracement zone (50-62%) and the 200-day moving average. The Nasdaq had a similar setup working. Since that writing, the Russell 2000 peaked with a two-day reversal above 760 and broke below its May lows. Resistance around the 200-day moving average ultimately held. Now what? With this week's break down, the medium-term trend is now down on Chart 7. Broken support around 720 becomes minor resistance and the first level to watch for signs of resilience. The mid-June highs become key resistance, which is confirmed by the 200-day moving average. Now that the Russell 2000 is in a medium-term downtrend, it is time to think about downside targets. The next support zone resides around 680-685 (yellow area) to mark the first downside target.

Chart 6

Chart 7

ARE SMALL-CAPS GETTING VULNERABLE?... The Russell 2000 represents small-caps and the S&P 100 represents large-caps. Comparisons between these two indices can tell us if the market prefers small-caps (speed boats) or large-caps (tankers). The preference was clearly for small-caps from early May to early June (yellow area). As the bottom window on Chart 8 shows, the S&P 100 went south, while the Russell 2000 headed north. The top window shows the price relative, which is the Russell 2000 divided by the S&P 100. This ratio ($RUT:$OEX) rises when the Russell 2000 outperforms the S&P 100 and falls when the S&P 100 outperforms the Russell 2000. It was all about small-caps from early May to mid June as the ratio surged from 1.11 to 1.21 (+9%). Even though the Russell 2000 is still outperforming the S&P 100 over the last few weeks, this ratio took a big hit over the last six days (orange area). As the Russell 2000 broke its May lows, the price relative also fell sharply as selling pressure in small-caps intensified. This group led the market from mid March to mid June. Loss of small-cap leadership would be negative for the market overall. This is something we should watch.

Chart 8