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Bond Market Price Falls Signaling Inflation and Rate Rises Despite Recession

Interest-Rates / US Bonds May 21, 2008 - 12:34 PM GMT

By: Paul_J_Nolte

Interest-Rates Best Financial Markets Analysis ArticleEnergy and food prices continue to rise – even though the consumer price index reflects a “quiet” inflation picture. Housing remains soft, especially single-family home, which showed a decline in the last report – along with lower home prices. The 10-year bond is pushing 4% for the first time this year. Yet stocks continue their trek higher – stopping a couple of times at the 13,000 mark on the Dow (other indexes have cleared recent peaks). With another round of mortgage resets lurking in the future, could the markets be whistling past the proverbial graveyard? The drumbeat of capital-raising by banks continues, yet many are commenting that we are now past the worst in the financial crisis.

At its' worst, the markets corrected 20% from their peaks (on an intra-day basis) and have since raced higher, severely reducing the negative returns for the year. Quoting Peggy Lee (again!) – is that all there is? If that's all there is my friends, then let's keep dancing Let's break out the booze and have a ball. Unfortunately these late-night parties have a way of lingering well into the next afternoon! As long as the real estate mess remains contained (big if!) – indeed, let's keep dancing!

After dipping back into the range and getting us excited that a correction of the March move higher was at hand, stocks traded higher all week. Now comes the next test, the 200-day moving average. While technical in nature, many investors look at the average price over the last 200 days to determine whether the markets are in an up or down trend. With a few exceptions over the past five years, the markets have not only traded above that average, but also the average has been moving higher.

That changed this year, when the markets began their most recent fall. Not only did the markets slice through the 200-day moving average, but also the average itself began to decline. If the 200-day moving average indeed is a ceiling for stock prices, then we could see a correction that would push the SP500 down toward the 1350 level before setting up for another rally phase. The market characteristics have changed with the peak in October, as the rally phases have been short and shallow, while the declines have been long and deep. If the markets can clear the next hurdle, then we might be able to change our views about the markets and become more bullish toward stocks in general. However, with a still richly valued market we doubt there is much left in the tank to significantly push prices higher.

If inflation is not a serious threat to the markets, then why are bond prices falling (and yields rising)? Could the bond market sense something that the rest of us feel (but is not indicated by the “official” government statistics? Our bond model has been negative for the past three weeks, indicating that yields should remain high and rise over the very near term. The model usually is negative for a period of 9-11 weeks and this time could see the 10-year yield push past the 4% level. In fact, this week the Fed Funds futures indicated for the first time since last summer that the Fed would be raising rates soon. We will allow the markets to settle themselves over the next few weeks before we get aggressive in buying bonds as recessionary fears should come back to the fore in the summer months. 

By Paul J. Nolte CFA

Copyright © 2008 Paul J. Nolte - All Rights Reserved.
Paul J Nolte is Director of Investments at Hinsdale Associates of Hinsdale. His qualifications include : Chartered Financial Analyst (CFA) , and a Member Investment Analyst Society of Chicago.

Disclaimer - The opinions expressed in the Investment Newsletter are those of the author and are based upon information that is believed to be accurate and reliable, but are opinions and do not constitute a guarantee of present or future financial market conditions.

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