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Ten-Year Turning

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I wrote yesterday about the bond market's reluctance to sell-off in the face of strong economic data. That is, the yield of Treasuries remained in a descending trend, threatening to breakdown. (Remember that yield moves inverse to price.) The tone in bonds today is markedly different following this morning's economic data.

We (Jeff Bailey and I) monitor the bond market closely for its impact on stock prices. There are two reasons for our concern with bonds: 1) The bond market is "smarter" than the stock market. 2) The bond market is bigger than the stock market.

Following the better-than-expected Chicago PMI number yesterday, the Institute for Supply Management reported this morning that its ISM index rose to 54.7 percent in February from 49.9 percent in January. A reading above 50.0 reveals expansion in economic activity. February's reading is the strongest since April of 2000 -- the index has been below 50 for more than a year-and-a-half. In other words, the manufacturing sector has been in recession over that same period.

The ISM number reveals growth in the manufacturing sector which is what the market's been revealing over the last two months. Jeff and I have been the most bullish on stocks levered to the early stages of the business cycle, such as transports, basic materials, and heavy equipment makers. The runs in Honeywell (NYSE:HON) and Caterpillar (NYSE:CAT), for example, discounted a return to growth in the manufacturing sector.

Even with the measurable advances in certain stock sectors in the last two months, which were portending a return of economic growth, the bond market continued to trade with a bid through yesterday's session. Accounting for today's move, the yield of the benchmark 10-year Note (TNX.X) remains in a descending trend, but we're starting to see some upside work in yield (selling in bonds).

There are two conditions under which capital would move out of bonds and into other investment vehicles. The first would be under inflationary conditions. The second would come if bond market participants perceived a better risk trade-off than bonds.

Today's ISM number helped to revive the market's expectations for inflation as the Fed Funds Futures market is again discounting a rise in short-term rates by this summer. Part of the sell-off in bonds today is due to expectations for inflation.

But, and it's a big one, credit concerns continue to linger. Bond market participants remain reluctant to take on additional risks associated with corporate debt and common stock. The deterioration of credit quality among many sectors of the economy, such as telecom, have kept many would-be buyers of corporate debt and stocks parked in the safety of the Treasury market.

We are seeing some upside work in yields (selling in bonds) today. But the TNX.X is back at a key resistance level that has kept it lower for the last two months. I posted a point and figure chart of the TNX.X yesterday, pointing out its bearish resistance line. The TNX.X traded up to that line this morning but has not yet been able to advance further.

TNX.X - P&F Chart (.50 Point Box Size)

Not until the 50.50 level will the TNX.X generate a new buy signal and reveal substantial selling in bonds. While the yield has put in some solid upside work in today's session, we really need to see it break above its short- term resistance to create an environment in which stocks become very attractive to those would-be buyers.

The daily chart of the TNX.X reinforces the short-term resistance to which the yield rallied today. The descending trend line corresponds with the 50- and 200-dmas.

TNX.X - Daily Chart

While the economic data and reversal in bonds bodes well for stocks, we still need to see some more upside work in yield. The economy is on its way to recovery, but that doesn't mean all stocks rally from here.

Those companies levered to the early stages of the business cycle will be the first to benefit, in terms of revenue and earnings growth, from an increase in economic activity. The transports, basic materials, and equipment makers, among others, will be the first to see an improvement in their financial positions. But other sectors of the market remain mired in recession; more specifically, technology and telecom still have their troubles.

The credit concerns stemming from the aforementioned two sectors, among others, may continue to hold back yields as the safety of the Treasury market remains comfortable. The way a trader can monitor the bond market's sentiment is through watching the levels I've discussed herein for the TNX.X.

Eric Utley
Option Investor

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