Chart Presentation: Leading

At top right we show crude oil futuresand the Hang Seng Index from 1998 through 1999 and into early 2000. Below right we show the same comparison from May of 2007 to the present day.

The argument here is that the lows for the Hang Seng Index preceded the bottom for crude oil by more than six months back in 1998- 1999. The Hang Seng bottomed with theCanadian dollarin August of 1998 while oil and copper prices remained weaker into the first quarter of 1999.

If the Hang Seng Index leads crude oil futures prices then any decline or weakness inoil pricesthat has not been preceded by a cycle peak in the Hang Seng Index (and Canadian dollar) is obviously suspect.

If we take this a step further and argue not only that the Hang Seng Index has to peak and turn lower but it has to continue to decline for at least six months before there is any chance of sustained price weakness for energy prices… then perhaps the present markets situation makes a bit more sense.

We have usedequity indices from China, Hong Kong, and even India (yesterday’s issue) to make the case that Asian growth appears to be slowing. We have shown comparisons based on ocean shipping rates to argue that the U.S. dollar appears to be in the process of working through a major base. We have suggested that copper prices turn to the down side ahead of crude oil prices and have hammered away at the notion that as the dollar firms we should see downward pressure on commodity prices in general.

In previous issues we have compared crude oil to the Nasdaq Composite Index from 2000 and even compared it to the Hang Seng Index back in 1997 to make the argument that the first break for crude oil prices could come as early as the second half of June. We argued as well that a top for oil prices could coincide with 10-year Treasury yields rising above 4.0% (currently 4.245%). The only thing missing is an actual decline in crude oil prices. Until crude oil futures break below the 50-day e.m.a. line (roughly 122) the trend is still very simply and equally obviously higher.

It is difficult to argue that any one particular number represents a major change in trend but for years we have been arguing that if Japanese 10-yearbond yieldsrise above 2% we will view this as an indication that Japan’s very long flirtation with deflation has come to an end.

As of yesterday Japanese 10-year yields had risen to 1.88%.

At right is a chart of the Japanese 10-year (JGB) bond futures. Our sense is that there is something about the 131 price level that the markets are viewing as important.

Below right we show the JGB futures and the ratio between equities (S&P 500 Index) andcommodities (DJ AIG Commodity Index).

Japanese 10-year bond futures pries declined to the 131 level around the end of June in 2006 and then pivoted upwards. As the bond market rallied the equity market outperformed thecommodity marketso that the equity/commodity ratio resolved higher.

We show a chart of Morgan Stanley (MS) below. MS is an example of a stock that pivoted higher around the end of June in 2006.

The JGBs returned to the 131 level at the end of June one year later in 2007. Once again the bond market rallied but instead of favoring the equity markets the trend was driven by a collapse in thefinancial sectors (i.e. Morgan Stanley) and a major rally in the commodity markets.

The point is that at the end of June in each of the last two years the JGBs have fallen to 131 which represents a yield just below 2.0%. In 2006 the bond market rallied as equities outperformed commodities while in 2007 the bond market rallied in price as commodities outperformed equities. In 2006 falling commodity prices provided the justification for higher bond market prices and lower interest rateswhile in 2007 it was clear that interest rates had to decline because the major banks were heading into a mortgage-related crisis.

As we approach the end of June this year we can see that 10-year Japanese yields are rising rapidly as the JGB futures plummet back towards the 131 level. Our sense is that this time the JGBs are going to break below 131 and that this will mark the end of the yen carry trade the spread between Japanese and Europeaninterest ratesnarrow. It is also our conviction that even as analysts and economists fret about the negative impact of higher interest rates and a stronger currency… this will mark the beginning of a major recovery in Japanese asset prices.