Last week we looked at the shellacking that the municipal bond market suffered and I offered some reasons why that market was about to experience a reversal of fortunes. Today I wanted to talk about the much larger US Treasury bond market and argue in a similar vein that the bond market is also about to rally along side its municipal brethren.
There are several reasons why I believe this. One, the sentiment picture in the bond market looks very lopsided with most believing that we are about to see further losses. Given the decline we’ve already seen, this negative sentiment bodes well, from a contrarian viewpoint. As well, a simple but effective technical indicator is also signaling that we are about to see a trend change.
Bond Sentiment
The Rydex Inverse Government Bond Fund allows retail traders to bet on declining Treasury bond prices (or a rising yield). Like other Rydex mutual funds it provides us with a good indicator of retail investor sentiment towards a sector. We’ve recently looked at similar indicators for the Energy Services sector and the Precious Metals sector as well.
In keeping with contrarian sentiment, we’d expect Rydex mutual fund investors to pile into a fund en masse when a clear trend establishes itself and then to reach a crescendo at the peak. Then, that money flow is unwound as the sector loses ground. This is exactly what we see happening in the Rydex (inverse) government bond fund:
The above shows the total assets of the fund (in millions) compared to the iShares 20+ Year Bond ETF (TLT). There is a clear inverse correlation. As retail investors chase recent returns, they balloon the total assets of the fund. And when they abandon this specialized fund, a major top is formed. They are almost consistently wrong at every major inflection point. And therefore, a great contrarian indicator.
Right now, the fund’s assets are $660 million, very close to the recent ‘ceiling’ of appx. $700 million marking major bottoms in TLT. In other words, this level of enthusiasm for this inverse fund means that the down trend in bond prices is either very close to or already finished.
Other sentiment measures are pointing to the same conclusion. For example, Consensus’ sentiment survey for Treasury bonds is down to 26% bullish. Historically, when we see so few bulls the bond market has rallied. Technically, I’d prefer to see the bullish percent get down to the low 20%’s but you can’t have all the stars align perfectly.
Another sentiment measure, the MarketVane Treasury Bond sentiment indicator is at 47%. That may seem to be middle of the road at first, but this indicator is best used relative to its most recent historical patterns. Taking those cues, the current level is just slightly above what is considered a bullish percent low, the low 40%’s; taking this close to a contrarian bullish sentiment.
As well, the recent Commitment of Trader’s report from the CFTC shows that small traders have by and large given up on their recent large net long position. Just a few months ago they were holding slightly more than 40,000 contracts net long. Now they are short slightly less than 20,000 contracts.
Technically Oversold
Finally, looking at the chart of the US 30 year Treasury Bond price, we can clearly see that the recent drop has been overdone. A simple but effective technical indicator is to compare the relative distance of price to its 50 day moving average. Right now, the 30 Year Treasury bond is appx. 5% below its 50 day moving average. This is a relatively rare occurrence and historically has marked a major bottom for bond prices.
Looking at the bond market via a chart of the yield for the 30 year Treasury bond we can see that it is approaching a strong and long standing resist zone in the 4.6%-4.8% range. The last time yields touched this ceiling was back in April 2010.
In summary, looking at the various sentiment and technical indicators, it is much more probable that the recent downtrend in Treasury bond prices has exhausted itself and will reverse. This will, of course, resume the very long term bull market in bond prices. Far too many bears have thrown themselves in front of this raging freight train and their mangled portfolios are not fun to look at.
As a technical trader I won’t wade into the myriad economic arguments for why the US or the US government is doomed, a failing empire, etc. The bearish case is always much more eloquent and usually far more alluring than the bullish case. Avoiding its siren call is not easy. But I’m going to stick with the indicators that have served me well and couple it with the use of judicious money management.
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It is pretty inexcusable that this article does not even mention the most important dynamic in today’s Treasury markets: intervention by the Fed.
If the remaining Treasury purchases under the Fed’s QEII Treasury purchasing program are substantial enough to prevail against the bond vigiliantes, then yields will stay low-ish, and prices will probably stay where they are or improve somewhat.
If the bond vigilantees overwhelm the QEII Treasury purchases, the rates will obviously rise to reflect the enormous market anticipation of inflation.
The only reason the Treasury markets did not reflect this enormous anticipation of inflation during this past summer was because the Royal Bank of Scotland had already announced that the Fed was about to engage in a Treasury purchase program. Additionally, the american public was slow to realize that this program was in place, and so the vigilantee rise in yields was slowed.
Craig, technical analysis works on the basis that all facts pertaining to the market in question, even the intervention of the Fed, is reflected in the price by the participants. Therefore, by focusing on the price action and the sentiment that data point is inherently included in the analysis.
Babak, I think this may be a very good trade, and am wondering if at this point there are any CEFs in particular you are tracking?
This is a very good post. There is one main thing that I disagree with and that is the conclusion which is put forward in your post. It is the idea that Treasuries are “Technically Oversold”. Especially the quote stating that:
“In summary, looking at the various sentiment and technical indicators, it is much more probable that the recent downtrend in Treasury bond prices has exhausted itself and will reverse.”
I might be wrong here, and the market might prove you right instead, but I disagree with your view and here is why. I think that yields on the 10 Yr Note have reached an extreme sentiment and became technically overbought, precisely on November 05th, the same time US Dollar bottomed out. This obviously coincides with the FEDs announcement on QE 2.
If we look at basic technical analysis tools like MACD or RSI in the weekly chart, we can see that Bond prices are not oversold at all. The exhaustive move you must be talking about is only in the very short term time frame. I agree that bond prices could bounce here, but those bounces could and should be used as short entries. There is plenty more downside left for bond prices to fall, before they become properly oversold. Monthly charts also show this as well, and the monthly candle in November is a huge reversal signal for the bond market. So are the current 99 week mutual bond inflows coming to an end, but that is another story for another time.
As a contrarian, you should have alarmed the readers of your blog that bonds were a good short in early November, instead of trying to pick corrective bottoms which might last only a week or two. Also to note is that picking short term bottoms in a downtrend, or short term tops in an up trend, is not a contrarian trade – you are merely just attempting to trade against the trend. This is very dangerous as one almost always losses money trading against the main trend.
A wise contrarian trader bets against markets emotions when fundamentals are in his favour. This end up being proper infliction points, just like the one on November 05th for both US Yields and US Dollar. Other traders attempt to trade against the trend at any sign of “short term oversold signals” and than, more times than not, fail to make any proper money.
Either way good work on the use of tools and analysis.
I agree with your analysis. I am particularly troubled by the market’s extrapolation of a strong Christmas retail sales growth. In clients that I deal with that are not in retail, sales are slow as ever and in some cases declining. Christmas was strong because we had 2 consecutive years of bad numbers, making for easy comparisons and lots of pent up demand. The traditional non seasonal drivers of demand like housing and car sales are bad as ever. Just as last spring when everyone was sure we were headed for a big recovery I think there is zero evidence to support this. Every piece of good news has been fully discounted. Add to this the fact that Bill Gross just bought 17 million worth of his own bond funds with his own money would seem to indicate that buying bonds at this point in time is probably a nifty idea.
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