By Jason Pearce
A Noteworthy Setup In Treasuries
Everybody seems to hate the bond market right now. All the cool kids own stocks and commodities. After all, the new US President is going to Make America Great Again and he’s willing to spend whatever it takes to get us there. That’s not good for bonds.
However, there may be a good reason to consider a contrarian approach and start thinking about owning US Treasuries once again. Whether you are looking at cash bonds, futures, or ETFs, things may be shaping up for a major trend change. If so, the investor/trader who gets in early will be the one to reap the biggest reward.
Ebb and Flow
Last July the long end of the US Treasury market peaked at record highs. The yield on the 10-year note sunk to a record low of 1.33% as investors were snapping them up hand over fist. At the time, it made perfect sense. First of all, the yields on comparable treasuries in Japan and parts of Europe were negative. So an investor would pay the governments to take their money! In that context, it made the still positive yield in the US Treasury markets seem like a pretty good deal.
Also, the world had just been sucker-punched by the outcome of the Brexit vote a few weeks earlier. Stock markets made a quick and nearly immediate recovery after the vote, but the damage was already done. Due to the negative surprise and ensuing whiplash in equities, investment safe-havens were now in high demand.
In a case of bond market déjà vu, July of 2016 was somewhat reminiscent of the July exactly four years earlier. That was when the Greek debt crisis caused turmoil in the markets and safe-haven buying sent the US 10-year note yield to a then-record low of 1.39%. As Mark Twain once said, “History doesn’t repeat, but it often rhymes.”
As is often the case, that turned out to be the very top of the bond market and low for yields. At the time, nobody could imagine that Treasuries could decline in such an uncertain environment. Yet that’s exactly what happened. It reminds me of the classic Wall Street observation: People are the most bullish at the top and the most bearish at the bottom.
After reaching its zenith last summer, Treasuries have been hammered by continued improvement in the US economy, Trump’s election victory, a continued surge to record highs in the stock market, a rate hike from the Fed back in December, and the expectation of even more rate hikes for this year. Now it seems that nobody can imagine that Treasuries could rally in such an environment. It may be a good time to reread that Wall Street observation in the prior paragraph.
The Pendulum Has Swung Again
Bond market sentiment is at an extreme right now. But it is not the extreme bullish sentiment that we saw last summer; it is now extreme bearish sentiment. My, how rapidly things can change in just a few months.
Market speculators seem to think that Treasuries can only decline in the current environment. This bearish sentiment accelerated right after the election as stocks rebounded. The yield on the 30-year US Treasury bond made the biggest single day spike since at least 1977, driving the point home.
The general consensus has been that the Trump administration will be a big boon to the economy as they go on a massive debt-fueled spending spree. If it materializes, it would cause a significant uptick in inflation and interest rates. Also, a major tax overhaul is being promised. Naturally, the bond market would suffer under the weight of all this economic stimulus.
A Stretched Rubber Band
Just how bearish is the prevailing market opinion right now? Fortunately, we can measure this opinion with more than just cheap words. According to the weekly CFTC reports, speculators reached the biggest net short position on record just a few weeks ago. Not just a short position in one particular instrument, but short across the entire yield curve. From Eurodollars (short-term deposits)…to 5-year notes…to 10-year notes…to 30-year bonds. They’re betting heavy on the short side.
These Commitment of Traders (COT) reports are used as an indicator to determine when markets are vulnerable to major trend reversals. Traditionally, one should look to take a contrarian approach to how the speculators are positioned. It is important to remember, however, that these reports are not to be used as a timing mechanism. Record positions can and often do continue to grow. As Keynes said, “The market can remain irrational longer than you can remain solvent.”
That being said, I believe that these COT reports are one of the better sentiment indicators out there. This is because the data doesn’t just show the market participants opinions, it shows their positions. In other words, we find out if they’re putting their money where their mouth is. And right now, all their money is highly-leveraged on a short bet on US treasuries.
Of further interest, Deutsche Bank pointed out that the size of this massive net short speculative position is a four sigma event. Experienced traders should know that the market does not fit neatly within the confines of a Gaussian bell curve. History has proven that market events create tails that are much fatter than should be expected. But you still have to admit that a market move of four standard deviations away from the mean is one heck of an extreme! This is not a sustainable situation.
Even if the spec crowd is right on the treasury market, they are currently so heavily short that a simple bear market rally could cause massive short-covering as buy stops are triggered. It may be starting already, as they have been trimming back a bit on some of the short positions on the long end of the yield curve over the last couple of weeks. Of course, this may be offset by the fact that they have added to short positions on the short end (Eurodollars).
If the short-covering does start to get some traction, it could have a domino-effect of pushing prices even higher and triggering buy stop orders, causing bonds to overshoot on the upside. Wash, rinse, repeat. The situation is akin to a rubber band that has been stretched to the point of breaking or snapping back violently and suddenly. This means that there may be serious money to be made by the contrarian who finds a good setup on the long side of Treasuries.
Trumped Up Hopes
The US stock market made an about-face when the election results came in. Donald Trump’s surprise victory was the catalyst for a multi-month run to new record highs. As stated earlier, this is predicated on the idea that Trump will be a very pro-business President. He has promised to lower taxes, roll back cumbersome regulations, and build infrastructure.
But here’s the problem with that: the markets seem to have already priced most of these expectations in. This makes it vulnerable to corrections if progress occurs slower than expected. After all, it will take at least a couple of years to get the infrastructure spending implemented.
Worse yet, what would happen if Trump doesn’t deliver on all of his promises? Or what if the focus shifts negatively from building the economy to starting a trade war? Then the stock market goes from being vulnerable to a correction to being vulnerable to a bear market. In light of this, it appears that the market has currently put the cart before the horse.
As most investors already know, a meltdown in the stock market usually results in a melt up in the bond market. They don’t always move in opposite directions, but they certainly do during times of financial duress. This is due to the safe-haven status of US Treasuries. So when the stock market stumbles and Mick Jagger, a graduate of the prestigious London School of Economics, starts to sing Gimme Shelter, it will be high time to make a B-line to the bond market.
The odds of a setback in the stock market are increasing. Regardless of what you believe Trump’s effect on the economy will be, there are other reasons that the stock market could be in for a reversal this year. The duration of the current bull market, the size of the current bull market, and the convergence of different stock market cycles all indicate that this record bull market is long in the tooth. By extension, this argues that the odds favor a recovery in the treasury market. (We’ll go into more details about the stock market’s vulnerability in a later article).
Are Rate Hikes Good For Bonds?!
Back in December the Fed raised rates for the first time in a year and the second time in a decade. With the US economy in expansion-mode for the last seven years and the unemployment rate dropping low enough to achieve the full employment level, it’s widely-expected that the Fed will raise rates even more this year. Some analysts are even projecting two or three more rate hikes in 2017. This should continue to drag the bond market lower as rates and bond prices are inversely related.
Higher yields on bonds could actually be the very thing that brings demand back into the Treasury market!
If the Fed raises rates a full percentage point in 2017, bond funds will suffer likely a loss for the year. But the next year could produce positive cumulative returns. This is because the interest and principal will be reinvested at a higher rate. If you were to extrapolate the effect of the higher rate further into the future you will see that the annual return grows even more in each successive year. Again, this is because the higher interest rates will compound the growth on the capital growth at a faster rate.
We all know what happens when a security offers a higher return: demand increases as more investors want in on the action.
The Fed’s Folly
Another way that further rate hikes could potentially be a boon for bonds would be if the Federal Reserve were to get too far ahead of the curve. Tightening monetary policy too swiftly could choke off economic growth. This would send rates right back down. As a matter fact, treasury yields could go back down even before the Fed even starts to throttle back.
Before you go thinking that modern day central bankers are just too educated and experienced to do something that crazy, I’ll remind you of a central bank episode from just a few years ago.
Back in 2011, the ECB hiked rates two different times because of a temporary pickup in inflation. The first rate hike was done in April. This smashed the 10-year Euro bund down to a one and a half year low. However, the rate hike was done during an economic crisis. Remember the PIIGS? Not a smart move. The Treasury market even said as much. When the ECB hiked rates again just a few months later in July, the Euro bund rallied to a multi-month high. Not surprisingly, the rate hikes were undone before the year was out as the ECB had to backtrack and start cutting rates again.
Did you notice the part where the Treasury market rallied when the ECB continued to raise interest rates? This is because the bond market is smarter than the central bankers. The Fed may be able to change rates on the short end of the yield curve, but the long end of the yield curve is driven by market forces.
There are obviously a lot of differences between Europe in 2011 and the US in 2017. The US is certainly in a much better position to justify rate hikes than the ECB was. But my point here is that the track record for central banks is not one to put your faith in. They have a knack for repeating their mistakes and the mistakes of others. The bond market will not hesitate to call them on their folly and even run contrary to their mistakes in monetary policy.
Building a Base
Many ‘experts’ are saying that the 35-year bull market in bonds has finally come to an end. Of course, many of these same ‘experts’ shouted this from the rooftops in 2011, 2012, 2013, 2014, and 2015 as well.
But just for fun, let’s suppose that the boy who cried “Bear!” is finally right. What if this multi-decade bull market in bonds actually did come to an end at last year’s top? Does that mean bonds will accelerate into freefall mode?
Not necessarily. There is no historical precedent that indicates that T-bonds have to go into a death spiral from here even if the bull market is over. If you want to get ‘macro’ for a moment, look at the last two hundred years of history for the US interest rates. What happened when prior multi-generational bond bull markets came to an end? They were followed by multi-year basing periods.
After the sizable rally off the 2016 low in yields and the pullback from the record high price, history suggests that there should eventually be some significant retracement of the move. It takes time for markets to adjust to a new paradigm after a multi-decade trend. If so, it means that bonds could establish a buyable bottom -if it hasn’t already done so- even if this is the start of a secular bear market.
Focus On Price
Anyone can call for a rally in bonds and be right…just as long as they don’t predict when it will happen. But if you want a forecast to translate into profits, you have to be accurate on your timing.
One if the best ways to time the markets is to focus on the simplest and purest data set that we can find: price. This is where you know longer care about the why; you only focus on the what. Tune out all of the news, fake or otherwise, and simply focus on the price behavior of T-bonds. You will see that the behavior of this market has been remarkably consistent.
I’m going to show you the simple pattern that has helped me identify many of the major tops and bottoms in T-bonds over the last decade or so. It’s the macro view for Treasuries. A lot of traders miss this view completely because they are so focused on the short-term zigs and zags. In a world full of day traders, plagued by ADHD and Twitter addictions, having a macro view on things will give you a major advantage over the other market participants.
For the last thirty years, T-bonds have been trending higher in an upward channel. Unfortunately, the price charts for the T-bond futures contracts is not as clean as I’d like it to be. It does not adjust for when the Chicago Board of Trade changed the notional coupon for all Treasury futures from eight percent to six percent, which started with the March 2000 contracts.
Since the futures price data is not up to snuff, we can examine the inversion of the price pattern by looking at a chart of the 30-year bond yield. Remember that price and yields move inversely. Therefore, the bond bull market means that the yield has been trending lower in a downward channel for the last few decades.
Observations of ‘Interest’
Bond yields have basically been moving in a pattern of descending Major Swing Highs and Major Swing Lows for over three decades. Every Major Swing High was lower than the last and every Major Swing Low was lower than the last.
The Major Swing Lows were established in July 1986 (7.12%), October 1993 (5.78%), October 1998 (4.69%), June 2003 (4.14%), December 2008 (2.52%), July 2012 (2.45%), and quite possibly July 2016 (2.10%).
The Major Swing Highs that followed were established in October 1987 (10.25%), November 1994 (8.17%), January 2000 (6.75%), May 2004 (5.60%), June 2009 (5.07%), and December 2013 (3.97%).
The next thing to investigate is the size of the rallies from the Major Swing Lows to the Major Swing Highs. There are two ways to look at this: in basis-point terms and in percentage terms.
Measuring in terms of basis points, the size of the rallies from the Major Swing Lows to the Major Swing Highs was 313-bps. (1986 to 1987), 239-bps (1993 to 1994), 206-bps (1998 to 2000), 146-bps (2003 to 2004), 255-bps (2008 to 2009), and 152-bps (2012 to 2013).
Since rates were moving progressively lower during the last three decades, the sizes of the rallies off the Major Swing Lows were getting smaller as well. The 2008 to 2009 rally was an outlier in the series, of course. This is not a surprise since it occurred during –and because of- the Great Financial Crisis.
Measuring in terms of the percentage gain, the runs start to look even more uniform. The rally off the 2008 financial crisis low was once again the exception in the bunch. The yield on the 30-year bond increased 44% from the 1986 low, 41% from the 1993 low, 44% from the 1998 low, 35% from the 2003 low, 101% from the 2008 low, and 62% from the 2012 low.
Next, let’s look at the duration of these moves. Knowing how long the rising yields took to complete the journey can help us set realistic expectations going forward.
The rallies from the Major Swing Lows lasted one year and three months (1986 to 1987), one year and one month (1993 to 1994), one year and three months (1998 to 2000), eleven months (2003 to 2004), six months (2008 to 2009), and one year and five months (2012 to 2013).
As you might have guessed already, the 2008 to 2009 event was an aberration as it only lasted half a year. The rest of the rallies lasted between just under a year to just under a year and a half.
A Technical Takeaway on Treasuries
If this thirty-year pattern of the 30-year bond yield persists, here’s what we might expect going forward:
The rally off the July 2016 record low of 2.10% should last about a year or a little more. Aside from the 2008-2009 rally, the durations lasted anywhere from eleven months to one year and five months. If so, the ideal timeframe for a final high in yields and low in bond prices will be the second half of 2017.
In basis-point terms, the rally could add 150 to 200 basis-points from last summer’s record low. That would project a peak in the yield between 3.6% and 4.1%.
In percentage terms, 30-year bond yields should increase 35% to 62% from the low. That puts the target yield range between 2.84% and 3.4%.
Finally, the rally should not significantly exceed the 2013 Major Swing High at 3.97%. In the last three decades, not one prior Major Swing High has been surpassed.
Bottom line: US Treasuries have already dropped precipitously from last summer’s peak and market speculators are record short down here at the lows. Equity and bond markets are pricing in major infrastructure spending, tax cuts, and more interest rate hikes.
If the stock market retreats or the Trump administration disappoints, a contrarian long position in Treasuries could offer a huuuuge (read in Donald Trump’s voice) payoff.
Watch the price action to determine the timing. If the 30-year bond yield ever makes it up to either side of 3.5%, it’s time to watch closely for any signs of a reversal.