Bond Market At Mid-year

As I have previously discussed, the US bond market is very
sensitive to the momentum of production plus sensitive materials
prices. The latest upturn in bond yields started around the
end of November, 2006 and it remains intact. Over this same
period, the six month annualized rate of change in cyclically
sensitive industry has risen from 3.0% to 10.2%. Since US
production has been sluggish, the damage to yields has come
largely from strong industrial commodities prices, reflecting
high capacity utilization rates and strong international
growth.

Although I was surprised by how weak May durables orders were
(as reported today), the lead indicators I follow closely are
still signaling a stronger second half for the economy. So I am
stuck with the view that bond yields may well trend irregularly
higher as the year progresses. Interestingly, there is usually
at least one period each year when industrial commodities prices
turn weak. That tends to occur around mid-year, perhaps because
smelters, mills and other smokestack production may elect to take
a little downtime in the warmer weather. At any rate, normal
seasonal weakness in sensitive prices could bring some improvement
in the bond market near term.

My super long term model, which regresses the Treasury bond yield
with inflation, suggests the bond should now be yielding between
5.75% and 6.25%. Trading around 5.20%, the long guy is well below
the indicated range. So, the premium for interest rate and inflation
risk has trended down in the new century. I attribute it to the
combination of strong financial liquidity coupled with moderate
inflation levels as well as the role of Treasuries in a variety of
swaps and other derivatives programs. I am not happy with this
explanation because Treasury yields do not correlate that well
with liquidity trends. I am also figuring that a combination of
eventual faster US production and ultimately higher sensitive
materials prices might bring the long bond yield closer to the
indicated 5.75 - 6.25% range.

The long Treasury yield is however high enough to trade now, which
I did recently. The investment case remains unappealing, especially
since there is decent grade short paper out there at 5.25 - 5.50%.

I note that the spread between high yield or junk bonds and Treasuries
is an exceptionally narrow 300 basis points. Since junk trades like
junk in more stressful economic times, no one is being adequately
compensated to own the stuff now. As the economic expansion
matures, the eventual migration to quality will begin....

Monetary Policy At Mid-year

The best economic trackers of monetary policy have been
trending down in concert since mid-2006. There was
sufficient weakness in the data around year end to trigger
a decision to cut the FFR%. The Fed passed on this option
and triggered the Greenspan commentary about a one in three
chance for a US recession by late 2007.

Now, the data is perking up, particularly for manufacturing.
With the basic trends still down, the Fed is expected not to
change the level of the FFR% on 6/28. However, if the economy
does continue to firm up as we move through 2007, those down
trends in the data series will likely reverse to the upside,
and change the psychology of expectations concerning short rates.
I continue to remain keenly interested in the balance between
production supply and demand as the US moves forward. Rising
capacity utilization normally creates cyclical inflation
pressures.

The Fed will also have to monitor oil and petrol prices closely.
Soon, oil will move into a seasonally strong price period which runs
into autumn and is already in a potent price uptrend from the Jan. '07
low of $50 per bl.

Inflation Situation

Headline inflation -- which is what people experience--
headed up sharply through the first five months of this year
reflecting not only a rebounding oil price, but a sharp
rise in gasoline realizations as well. The momentum of oil
producer crude lifting or downstream profits has been fading,
so focus has shifted to uptream profit generation via product
refining. In addition, there are increasing signs that US
economic growth will accelerate over the second half of this
year, and factory operating rates can be expected to rise.
This development can put further upward pressure on materials
prices. The growth of productive capacity has dropped to a scant
2.1% measured yr / yr through May.

My longer term inflation indicator -- a combine of selected
commodities and operating rate composites -- fell sharply over
the second half of 2006. The decline was steep enough to be
reminiscent of recession primarily because of the blow out of
the oil price as industry carry stocks mushroomed. Now, the
indicator is moving up, although June has been a quiet month.

There is no indication yet that a more prolonged acceleration
of inflation is set to occur, but with econ. output poised to move
ahead more firmly, the economy may regain an inflationary bias
beyond developments in the oil and petrol markets.

Stock Market -- Technical

Back from the precipice came the market in
a blistering rally to end an interesting week. The technicals
had the SP500 poised to fall. The 10 yr. Treasury rallied,
the boyz covered their stock shorts and the buy-the-dip
crowd finished it up. I mentioned there could be a surprise
with the Treasury so oversold, and that's what we got.

For the short term, I do not have much to say on the technicals.
The market still looks vulnerable, but what the hell, we've
had one surprise, so I am not going to argue with the tape.
Not good for one's nerves.

Correction To Entry Just Below

The link to the weekly chart in the prior 6/12
"Stock Market -- Technical" note below is not working right.
So a new link to the weekly chart for the SP500 has been
established in this note and should be viewed in conjunction
with the note below. Weekly chart.

Stock Market -- Technical

Well, the amber caution light is now glowing more
brightly for the market. The SP500 daily now has
its 10 and 25 day moving averages turning down.
This is not yet the case for my NYSE internal
supply / demand model, but the SP500 commands respect.
There is a link to the chart just below. Note also
the negative head of steam for the MACD. Daily chart.

The weekly SP500 chart is on a link below. Here we see
that both the weekly stochastic and the MACD are closing
in on breakdowns. Weekly chart.

Both charts are signaling that the market is getting close
to turning down. They are not sell signals, but warning signs.
As such, one should pay heed, while recognizing that the
market can dish out surprises. I am edgy about this situation
because the Treasury Bond -- a driver of this spate of stocks profit
taking -- is getting quite oversold short term.

Gold Price -- $650 Oz.

The price of gold has broken down from the powerful
uptrend line underway since mid-2005 on my tattered
semi log chart. This is not necessarily a bearish
development, but it is a "heads up". Sometimes a break
like this is just a fluke in an ongoing trend. Sometimes
such a break is fatal, and, sometimes it is a warning of
a break to come. So, you have to pay attention.

Gold is at short term support at $650 oz and the bugs may
move to bounce it up next week. Even so, a reliable trend
support has been violated and the game may be changing
as a result. Weekly $GOLD chart.

The Long Treasury ($TYX)

I still view the bond market as overvalued, so I do not
post much about it. However, the recent spike up in the
yield on the 30 yr Treas. is interesting. I like to
watch bond yields against their 40 wk. moving averages.
When yields stray 40 or more basis points from the
averages, it is worth noting, as a trade might be at
hand. The $TYX at 5.25% currently, is over 40 basis
points above its 40 wk. M/A. When you think of the bond
in terms of price, it is fair to say that it is becoming
oversold. As you will see on the $TYX chart linked to
below, the 10 week RSI suggests it is oversold, and
interestingly, the yield has moved up to significant 12
month resistance. Worth keeping an eye on.

The Treasury has responded to the significant upticks in
the ISM Surveys of new orders for both manufacturing and
services for both April and May, continuing low unemployment
insurance claims and the steadfast climb of industrial
commodities. Bond players have grown concerned that a
possibly stonger US economy could scotch expectations for a
lower Fed Funds rate and also lead to further inflation.

However, by my approach, the technical signs now say I
should watch to see if there might be a mildly good trade on
the long side of the market. The $TYX chart.

Stock Market -- Technical

The broad market remains in an uptrend. Recent
momentum loss and today's sell-off have erased the
case for a short term overbought condition. However,
viewed in the intermediate term (3-6 months), the
market, although still in a clear uptrend, is both
extended and overbought, even when operating within
the confines of the strong upward trajectory underway
since mid-2006. The intermediate term work does not
presage an imminent correction as it stands, but it
does suggest a little caution is in order. I have
linked to the broad Value Line Arithmetic index ($VLE)
below.I like this one because it includes the top
mid and small caps along with the majors, but is not
capitalization weighted. The $VLE.

Gold Price -- $670 0z.

Gold remains in a long term bull market and the price
is holding the strong uptrend that started 07/05.
Gold has yet to recover the highs seen at the end of a
parabolic blow-off top which wound up during 05/06.
This is not a source of concern as long as the metal
holds the trend from 2005.

The macroeconomic indicators remain positive for gold.
The primary indicator is just a touch below an all time
peak, largely reflecting a continuing advance in the
broad industrial commodities component (oil included)
since year's end. Another measure -- the $ cost of
heavy industry production is at an all time high. My
global economic supply / demand pressure gauge is in
high ground, although below last summer's peak due to
a work-off of excess oil inventories. The micro model is
up sharply because mining companies are producing low
grade ore under the $650 + oz price umbrella.

The ratio of credit driven liquidity to monetary liquidity
is in a strong uptrend. This will not favor gold unless
the metal's fundamentals are positive as they are presently.
The tailwind from credit liquidity is likely adding about
$120 per oz to the gold price presently.

Gold price chart is included. It is recovering some with
chart support at $625 - 630 0z. Chart.