Unruly Bond Market Could Nip Stock Rally In the Bud   

• Investors over the past several weeks have been focusing on whether slowing declines in economic data are actually green shoots of a recovery.
• But we believe they should have been watching the bond markets closer for possible triggers that would nip the post March lows rally in the bud.
• The 30-year TB has crashed below its 200-day moving average, with the 10-year TB in close pursuit, despite direct Fed purchases. Moreover, there remains the risk that a treasury auction could actually fail, which would be a shock negative for stocks. Bond auctions have already failed in Germany and the UK, and the recent auction of 30-year treasuries drew a very tepid response.  The corollary to falling bond prices is a similar drop in the USD index below its 200-day moving average, which exacerbates the losses for foreign buyers of US bonds.
• Unruly bond markets imply rising interest rates that at some point will crush the stock rally which is running more on the hope of a recovery than verifiable evidence.
• That said, our working assumption is that any re-test of March lows will not take stock prices below these levels, or even seriously near them.  The Nikkei 225 can be expected to move in sympathy, but we see strong support in the Nikkei 225 at 8,000, which represents only modest downside risk of 12% from current levels.
• Major Japanese companies like Toyota and Sony are projecting another year of big losses in FY09 instead of recovery. This suggests they are assuming no significant recovery in global supply-demand conditions even though month-to-month declines are already bottoming in other words, not even a decent square root-shaped recovery, as suggested by Merrill Lynch's economic team. Stock prices are trying to discount something different.
• Supply-demand Japanese stocks remains hampered by domestic institutions and individuals, leaving mainly foreign investors and broker/dealer prop traders to support the market. With no "home bias" among domestic investors, Japanese stocks remain susceptible to the whims of foreign investors, which fortunately for now are willing to take a revisionist view.

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