Sometimes the markets don't reflect what happened (a.k.a. the fundamentals), but who is buying and selling (a.k.a. supply and demand.)

Tuesday's rising Treasury bond prices and falling yields were more the result of Asian central bank-buying than a weak New York Empire State manufacturing survey, according to traders. Oil and other commodity prices continued to fall as hedge funds pull riskier investments off the table to ready themselves for a possible liquidity withdrawal.

Meanwhile, the earnings parade had a negative tint Tuesday, but the Dow Jones transports continued their rally -- growing ever nearer to "confirming" the Dow Jones Industrial Average's latest record close; the latter index closed up 0.2% to an all-time high of 12,582.59.

As 2006 came to an end, hedge fund investors recognized the boost that still-ample liquidity provided to financial asset prices around the world, particularly high-risk assets like emerging-market stocks, junk bonds and the commodities.

These short-term investors realize the biggest risk to their portfolios is a liquidity crunch, which could come as monetary policy in developed nations tightens to fight against the inflationary pressure that comes with all that liquidity. The Bank of England, for example, surprised investors with a rate hike last week for related reasons.

So, with bad memories of capital flight out of illiquid markets haunting them, hedge funds are "taking risk off the table" by "trimming positions" in oil and other commodities, says one hedge fund manager who declined to be named.

"It is the self-fulfilling prophecy of the stops," he says. "You sit on a profitable position for a long time, and move up your stops. Then your risk manager suggests you trim the position. The price goes down, and you hit the stop and blow out of the position. A lot of people were long in commodities, and as they trim positions, the price keeps hitting lower points and everyone starts coming out of it at once."

Oil fell another 3.4% Tuesday, which puts the price down 15% since the start of the year. Other commodities fell Tuesday as well, including copper, gold, heating oil and natural gas.

Indeed, OPEC doesn't seem concerned about supply and demand issues; Saudi oil boss Ali Naimi said new OPEC crude output reductions might not be needed. He also recommends investors not panic about the steep decline in prices.

So if oil and falling commodities aren't reflective of a weaker economy, it makes sense that Treasury bond prices plunged, and yields rose over the two weeks prior to Tuesday. Lower oil means lower inflation. Amid signs of a strengthening economy, all that adds up to the Federal Reserve on pause, and that traders unwound the three rate cuts previously priced into Treasury prices.

But the yield curve remains mildly inverted, presumably reflecting ongoing concern about economic weakness. Treasury prices rose while yields fell Tuesday. The 30-year bond rose 9/32 to yield 4.84%, while the 10-year gained 6/32 to yield 4.75%.

The buying wasn't about the New York Empire State Index, which measures manufacturing conditions in the New York region, says T.J. Marta, chief fixed-income strategist at RBC Capital Markets. The index read 9.1 vs. expectations of 20. The weakness makes sense, he says, noting that the Fed might get worried about an overheated economy if its 17 rate hikes didn't bring down these measures. Other regional indicators of manufacturing activity also have been soft recently.

"The Asians stepped back in," says Marta, noting Treasury traders were reporting Asian central bank bids throughout the night. "They were notably absent from the game and they came back in" when the 10-year's yield reached 4.8% last week. Given recent ranges for the 10-year between 4.5% and 4.75%, that makes 4.8% a decent entry point, he says, adding that without inflation pressures, he still forecasts one rate cut before the year is out.

The impact of foreign buying on yields is a much-debated subject on Wall Street, as many believe these investors have depressed the long end of the yield curve. Without foreign investors, yields would be 150 basis points higher or 1.5% higher, according to a 2005 Fed study. Their buying is what makes the yield curve "different this time," and not predictive of a recession, argue the authors of that report and many Wall Street economists.

So far, that analysis seems correct. But bonds could have another rocky day Wednesday with the next read on foreign buying of U.S. assets, the so-called TIC data, as well as the producer price index, industrial production/capacity utilization data and speeches from Fed presidents Janet Yellen and William Poole.

Barring any macro shocks, the stock market is likely to take its cues Wednesday from the next round of earnings data.

Shares of Intel ( INTC) climbed 0.5% ahead of its earnings report after the close, but were down 2.6% in recent after-hours trading. The chipmaker's fourth-quarter earnings and sales beat estimates, but Intel shares were up more than 9% year to date heading into the results, and the bar was thus set very high.

Shares of other semiconductor companies were weak on the day as well, with Advanced Micro Devices ( AMD) and Micron Technologies ( MU) falling 0.8% and 2.2%, respectively.

Shares of mining company Freeport-McMoRan ( FCX) slid 2.9% on its disappointing earnings while Commerce Bancorp ( CBH) lost 8.5% after reporting both disappointing quarterly results and a regulatory investigation.

As chief benefactor from a falling oil price, the Dow Jones Transportation Average climbed 2.1% Tuesday, which puts the index up 5.4% from its low point this year on Jan. 5. The transports, which have been a non-confirming, bearish divergence and thorn in the side of followers of Dow Theory, are now 2.7% below their all-time high of May 2006.

The rise doesn't mean much for the broad market unless it weathers a rebound in the oil price, says Phil Roth, chief technical analyst at Miller Tabak. "Right now it is just reflex and some aggressive traders," he says. Overall, "the market is swinging on traders and hedge funds and proprietary trading desks," Roth says.

The S&P 500 swung modestly between red and green Tuesday before closing up 0.1% to 1431.90. The Nasdaq Composite slipped 0.2% to close at 2497.78, largely due to concerns about weak earnings and guidance from Symantec ( SYMC), and a double-barreled analyst downgrade of Cisco ( CSCO). Symantec shares fell 13.5% while Cisco dipped 3%.

DuPont ( DD) and IBM ( IBM) powered the Dow as their shares hit two-year and five-year highs, respectively.

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click here to send her an email.

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