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Today Could Potentially be a Major Transition Day.

Yields on the US Treasury spiked to seven month highs early yesterday, the result of the absolute drubbing of European debt.  Treasuries rallied later in the day to post modest gains following IMF comments that the US should not increase rates until 2016.

Equities ended moderately lower on light volume, a session I believe was again dominated by ETFs and index trading.  Rising bond yields and failure of another round talks regarding Greece was the accepted catalyst for the yesterday’s equity decline.

As I have commented since Monday, today potentially could be a major transition day.   I am uncomfortable stating a specific date or price to mark a major change but there are three major events.

First OPEC.  It is widely accepted that quotas will not be cut.  What will be the verbiage and the attitude of the members given that every OPEC country is hemorrhaging financially with prices at these levels?  Will there be public animosity between Saudi Arabia and Iran, the Sunni and Shiite country/religious sect battling for regional dominance?

Second there is Greece.  Greece asked the IMF for a debt extension, requesting to bundle June’s obligations totaling about $1.7 billion in one payment due June 30.  It is the first such request from any country since the 1980s to ask for such an extension.  The ECB is pressing for an agreement by June 14.

The complacency around Greece is great. Yes Greece is background noise but has not impacted the markets.  Bloomberg writes the current trading range is the tightest at this time of the year since 2006.

Finally there is today’s jobs data.   Yesterday’s initial jobless claims were the lowest since November 2000.  Will the data suggest wage inflation?  Is this possible wage inflation a function of a lack of qualified workers rather a robust work force as evidenced by a low labor participation rate (LPR)?  Yesterday’s productivity data and unit labor costs suggests yes.

I have made extensive comments about the lack of liquidity, a function of ETFs, indexing and greater regulation.  I will argue the recent bond rout is partly a function of dealers reducing their trading activity amid regulations restricting their use of capital.

Fed data reports dealers have cut their US government debt holdings—the most liquid trading vehicle in the world—to $22.9 billion as of May 20, down from a record high $146 billion in October 2013.  There is now a void of market makers/dealers who will stabilize prices if selling commences.

I rhetorically ask what happens if selling starts in earnest, selling in both the equity and bond market, the result of the unexpected occurring?  I can make a case the indices could quickly decline 10% to 15% but the “typical” stock greatly outperforming given the dearth of ownership.  Regarding Treasuries, the recent rout would pale in comparison to the possible decimation that could occur.

According to Bloomberg’s “total return analysis,” if the yield on the 30-year Treasury rises a 100 basis points, the total six month return would be -31.41%.  Ifyields rose 200 bps to a 5.03% yield or the level nominally higher than February 2011, the six month total return would be -58.30%.

Can this happen?  No one suggested the 10-year German bund would rise from a record low yield of 0.049% on April 17 to almost 1.0% yesterday.

This is ugly!

What happen today?  The jobs data is due at 8:30 a 225K and 220K increase in nonfarm payrolls and private payrolls is expected, respectively.  The unemployment rate is anticipated to remain unchanged at 5.4%, a 34.5 hour work week, a 0.2% increase in hourly earnings and a 62.8% LPR.

Last night the foreign markets were down.  London was down 0.99%, Paris down 1.56% and Frankfurt down 1.44%.  Japan was down 01.3%and Hang Sang down 1.06%

The Dow should open moderately lower but this could change radically given the potential significance of the jobs data. Greece, OPEC/oil is also weighing on the markets as is the continuation of the rout of European sovereign debt.  The 10-year is off 8/32 to yield 2.34%.

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Ken Engelke

Chief Economic Strategist Managing Director

The views expressed herein are those of Kent Engelke and do not necessarily reflect those of Capitol Securities Management. Any opinions expressed are statements of judgment on this date and are subject to certain risks and uncertainties which could cause actual results to differ materially from those currently anticipated or projected. Any future dividends, interest, yields and event dates listed may be subject to change. An investor cannot invest in an index, and its returns are not indicative of the performance of any specific investment. Past performance is not indicative of future results. This material is being provided for informational purposes only. Any information should not be deemed a recommendation to buy, hold or sell any security. Certain information has been obtained from third-party sources we consider reliable, but we do not guarantee that such information is accurate or complete. This report is not a complete description of the securities, markets, or developments referred to in this material and does not include all available data necessary for making an investment decision. Prior to making an investment decision, please consult with your financial advisor about your individual situation. Investing involves risk and you may incur a profit or loss regardless of strategy selected. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. If you would like to unsubscribe from this e-mail distribution, please reply to this e-mail and indicate that you wish to unsubscribe in your response.