www.shaproperty.com

Figure 1: US 30-year bonds

In Figure 1, the market is at point 1 at time of writing - just below A but above B. I believe the market will form a low similar to the occasions at Q, R and S. On average the market has taken about 40 days from the high of the bar that first touched the parallel line. The April bar first touched the parallel line; its high occurred on April 5, 2006. This suggests that the 2nd standard deviation band ought to occur around June 2006 (40 trading days + April 5, 2006). In turn this suggests that the June FOMC meeting will mark the end of the interest hike cycle.

But as a friend often tells me: charts are all very well, but the real question is: what is happening in the real world (to support the idea that the interest cycle is likely to have come to an end)?

Well, in the real world, we know that the Fed will end its cycle of increasing interest rates once it is convinced the inflation beast has been tamed. To attain a forward looking perspective on the business cycle, I have been using leading indicators published by www.businesscycle.com. The indicators also provide me with advance notice of the inflation/recession picture. Figure 2 is the latest report and it shows an important fact.

Figure 2: Inflation watch by ERI

The inflation threat in the US is receding. Indeed if you compare the period I have marked by the rectangles A and B, the danger is not inflation but recession. ERI's Leading Indicator of Growth in Figure 3 supports this idea.

Figure 3: WLI growth by ERI

Notice that growth since 2004 has been anaemic to say the least. The growth in 2002 was much stronger and it nevertheless resulted in a recession. Should the leading indicator fall below the 0 line, this will be advance warning that a recession is under way. The ERI report suggests that at best the US economy will slow in the near future and at worst, it will experience a recession. In that environment, we can expect the Fed to at least stop raising rates.

This leads me to the next part of the article. If the Fed stops raising rates, won't this mean the US stock market will go up? The answer to that depends on the stage of the business cycle the US finds itself. Figure 4 shows the phases of the cycle.

Figure 4: Phases of business cycle (www.peterdag.com)

Phase 1: The economy slows below its long-term trend (below 50 in Figure 4). Investors can expect inflation, long-term yields (bonds), short term rates and commodities to decline. A bear market bottom occurs and a new bull market begins. Phase 2: The economy strengthens although its pace is still slow (still below 50). Investors can expect inflation, bond yields, short-term rates and commodities to stop declining. The stock market slows but it is still strong. Phase 3: The economy picks up a head of steam and is growing above potential. Investors can expect inflation, bond yields, short-term rates and commodities to start rising. Phase 4: The economy peaks. Investors can expect inflation, bond yields, and commodities to eventually peak. Short term rates tend to peak at the end of stage 4. The stock market is now struggling.

In my view we are at the early stages of Phase 4. Admittedly, the US economy is not giving a textbook picture. The yield curve has been inverting - suggesting a recession is to come; the short-term rates have probably peaked as has inflation. But commodities appear to have a way to go. So you could say we are in a topping process for the economy.

In such an environment, we can expect the stock market to rally once the Fed stops raising rates. But the rally will stall once the market realises that the problem is not raising rates but a slowing economy. At that point I'd expect a full blown retreat. Until then we can expect more of the same choppy price action.

This means that I expect that as soon as the Dow Jones Industrials finds a bottom, probably about 11,050 to 11,030, the market will have another look at the highs at 11,670. This will happen just as soon as the Fed pauses in the rate increases - if not before.

The Fed has stated that it will make its decision on the information before it. At this stage then the market will react to every important news event (eg. CPI, unemployment etc). And since these are lagging indicators I expect the data in June to be well below expectations. In turn this means we can expect a move up till June 29 when we receive the decision on the status of interest rates increase. Should the decision be for a pause we can expect further upward momentum. As the data becomes more bearish for the economy, the stock market will reverse and start a decline.

So, my view is rates will top out. The stock market will initially rally and this rally will be followed by a 2-year decline.

The writer is a private trader and investment adviser who regularly conducts trading seminars around the world