Why Both Stocks and Bonds Are Getting Risky

The June 28 U.S. Federal Open Market Committee meeting ended again with no change in the benchmark interest rate of 5.25%, and was accompanied by yet another ambiguous statement on future changes in monetary policy. The FOMC noted that the economy seems likely to continue to expand at a moderate pace over the coming quarters. Readings on core inflation have improved modestly in recent months. However, a sustained moderation in inflationary pressures has yet to be demonstrated convincingly.

For trigger-happy bond traders the omission of a somewhat elevated core inflation line, seen in recent monthly FOMC statements, was good enough to aggressively bid up beaten-down long-term bonds. This further extended the short-term rebound in the oversold bond market.

Though the tame core inflation data has been credited for the rally, bonds were, in reality, overdue for a rebound after the four weeks of nasty beatings taken between early May ’07 and mid June ’07. ETFs invested in long-term treasuries (AMEX/TLT) lost nearly seven percent over that period, a painful hit for long-term bond investors who are currently getting only five percent interest yield on their holdings.

Looking beyond the short-term rebound from the oversold conditions, the outlook for long-term U.S. bonds remains bearish. The dollar remains vulnerable to a sharp downside break through the major support at 80–$81 on the chart of U.S. Index. Had it not been for the Japanese Yen, which accounts for 14% of U.S. Index and is the only major currency that has been losing ground to the U.S. dollar, the U.S. Index would have already broke that critical support.

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Making the outlook for the U.S. dollar even more dismal is the high probability that the European Central Bank will implement further increases in its benchmark-setting interest rate. The Euro (58% of the U.S. Index) is in a well-established uptrend, and there is a high probability that it is coming to break above its previous all-time high of 1.36 U.S./Euro, first made in December ’04 and matched again in early May ’07.

Adding insult to injury, a number of foreign central banks and investment funds under their control have made clear their intentions to diversify their bond holdings away from currently heavy overexposure of their portfolios to U.S. treasuries.

Declining bonds means higher borrowing costs for both consumers, companies — which in turn may prove to be toxic for leveraged buy-outs (LBOs) — and equities in general. Depending on how high long-term interest rates will rise, LBO evaluation models will at some point start flashing the red light. The reduced LBOs may come at a time when the Street has already jacked up new IPOs to levels that, in the past, have often tripped market advances.

Sensing that it is getting a little late in the game, Blackstone (NYSE/BX) principals decided to cash in some of their gains by selling 10% of their private partnership as a public IPO on June 21, 2007. Offered at $31.00 a pop, traders briefly boosted it to $37.00 before profit taking brought it down to $29.27. In spite of the biggest hoopla generated by an IPO since Google went public, this is not another Google.

The omission of the elevated core inflation line, in the latest FOMC statement, has made less of an impression on equity traders. After a knee-jerk burst of buying, traders decided to pack it in for an early long weekend, leaving the stock indices little changed on the week and stuck within the trading range of the last two months.

Since early May ’07, the trading pattern on the daily charts of leading market averages has actually taken the form of a minor head-and-shoulder top. Breaks below the necklines would probably lead to a sizable market correction. The head-and- shoulder tops are especially prominent on the chart of the blue chip indices, until recently, the leaders of the market charge during 2007.