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The Biggest Bubble of Them All

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Bearish market participants have been screaming that the bond market is the biggest bubble in financial history. They’ve been banging the table and yelling that when rates rise, servicing the existing trillions in debt is going to require even more debt issuance. This will lead to ever-higher rates and a crowding out of the private sector.

Is the last card in the current bond game about to be turned?

Tuesday, 10-year US Treasury yields (USGG10YR) made a new high for 2013 as the Dow Jones Industrial Average (INDEXDJX:.DJI) closed at a new record high (unconfirmed by the Dow Jones Transport Average (INDEXDJX:DJT)). The spread between the stock market and the price of bonds looks like Jaws.

The Federal Reserve is going to need a bigger boat. What will rising rates do to their own holdings?

My gnome high in the Appalachians tells me that the bulls and bears alike are focusing in on the 2.20% yield on the 10-year as a big inflection point. He explains that above this level, mortgage-backed securities (MBS) holders are subject to extension and duration risk, leading to an increase in hedging which in turn would lead to price gaps and significant volatility.

The kicker is that due to a shortage of Treasuries due to Bernanke & Co. and low liquidity, higher rates even from such low levels could be very disruptive.

What if a rise in rates is not orderly?

The presumption is the Fed would respond to the disarray just like the Japanese Central Bank (JCB) responded last week to backstop their market.

But what if both central banks flip their cards, and the market calls their bluff? In other words, if the Fed actually has to increase buying on a further ratchet up in rates, it could be perceived as a very negative development for all markets.

Tuesday morning’s large gap and upspike in US markets was a sigh of relief to the wheels not coming off in Japan over the long weekend. So, it looks like Japan is the fox in the financial henhouse, where global markets used to take their cue from the US.

That said, the Fed and the JCB seem joined at the hip. It’s not a coincidence that when the Japanese version of ‘whatever it takes' started in November, US markets turned up in tandem.

US stocks are basking in the halo of the stratospheric rise of the Nikkei (INDEXNIKKEI:NI225). I can’t help but wonder whether last fall, with the fiscal cliff approaching at the end of the year and the US government needing to start cutting its budget, a concerted, coordinated game plan was hatched between the Fed and the JCB.

Yesterday, the long bond futures had its largest decline since October 2011.

One report states the 10-year US Treasury has seen the largest percentage increase in its yield (7.9%) since September 14 and the fourth largest increase in at least 50 years.

Apple's (NASDAQ:AAPL) 30-year 3.85% bond offering that was oversubscribed in May is down 7.4%.

Years hence, will it be apparent that the Apple bond offering pinpointed the ace in the hole that pricked  the bond bubble?

The irony may be as enthusiasm dwindled for Apple’s stock  and disappointment over a lack of new products, the Street lined up to buy its bond of which the execution for that product was right on target.

Bottom line -- If bonds continue lower (yields higher), I think Bernanke has a problem on his hands.

What could trigger the next selloff in stocks? Perhaps a fund loaded with stuff it can’t sell that must then sell what it doesn’t want to?

Yesterday, they ran another buy program up the flag pole, and the bulls saluted and got trapped long at a lower high.

Tuesday was the largest gap open since January 2, and I can’t help but wonder if as above, so below. Was yesterday’s gap a mirror-image foldback of the January 2 impulse?

While the opening spike caused bears to go into the fetal position, it found resistance at the key 1673 level which ties to May 21 and 22, the date of the recent large range Key Reversal.

So yesterday may have been a test of last week’s signal reversal bar.

Over the weekend, a friend sent me a note that the Dow bottomed after the 1929 crash at 41 (1932), and that 41 squared is 1681.

The Dow started at 40.95 on May 26, 1896. The intraday low in 1932 was 40.56 with a closing low of 41.22 on July 8.

40.56 squared equals 1645, and 41.22 squared equals 1699, giving a midpoint of 1672.

So, the Dow made a round trip 36 years (6 squared) after it started back to the same level.

This May 26 date makes the end of May a significant ‘vibration’/anniversary.

This is where the pre-crash pivot high occurred in 2008.

In addition, 1672/1673 is opposite November 21 on the Wheel. This, of course, was the crash low in 2008.

We have some significant vibrations at current price levels and time frames.

If a test failure of last week's signal reversal bar is playing out and the S&P 500 (INDEXSP:.INX) trades below yesterday’s lows, holds below those lows, and breaks below 1645, it should drop to 1600 quickly as shown on this hourly SPDR S&P 500 ETF (NYSEARCA:SPY) yesterday.

Conclusion: While the strength from the get-go on Tuesday initially looked like a picture perfect thrust off the S&P’s 20 DMA, there is a significant difference between last week's pullback and the other pullbacks in 2013 that tested the 20 DMA.

All other shakeouts undercut the 20 DMA. Even the shakeout that most resembles the current pattern (the pullback with an April 5 pivot low) was defined by an undercut of the 20 DMA.

Because the current pullback failed to ‘flush’ the 20 DMA and yesterday’s action tailed off substantially, it suggests there is unfinished downside business.

Strategy: The arbs may be trying to keep the market buoyed up into month-end and a rebalancing, but offsetting Tuesday’s upside gap is bearish. Doing so could see downside acceleration. Only above 1673 does the idea of a run to the round 1700 mark look doable in this time frame.

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POSITION:  No positions in stocks mentioned.