After months of persistent decline, the US government bonds have started to rally. Many in the media are attributing this to the unrest in the Middle East. That is a peculiar explanation since the catalyst was the Tunisian protests and government overthrow which began in December 2010. The bond market, I suppose, was asleep or away fishing during that event. Then Egypt followed in January and again, the media would have you believe the bond market was ignorant of it or choosing to ignore it. And then suddenly in February 2011 it started to pay attention to what was happening with the Libya protests.
The other, much more plausible, explanation is that the bond market marches to its own drummer. And we’d be better served by looking at technical and sentiment indicators. On that note, late last year I suggested that US government bonds were close to an intermediate low. It would seem that I was once again too early.
One of the indicators I pointed to was the total assets of the Rydex Inverse Government Bond Fund which had swelled in the face of the recent bond price decline. In early February the total assets of this fund (which is a bet on the decline of US government bond prices) provided us with a double top at $750 million. This recent top in assets fits nicely with the previous pattern not only because it acts as a contrarian measure but also because of the slight uptrend over time.
Other indicators which I mentioned also came into focus:
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.
Consensus did indeed fall to 20% and for a fraction of time even lower. It is now at a somewhat recovered but still very bearish 23%. Similarly, Market Vane’s bullish sentiment reading is also slightly higher at 50% from 47%. As well, on February 8th, 2011 the Daily Sentiment Indicator fell to just 6% marking the inflection point.
Tangentially, the municipal bond market seems to have come out of the recent crisis with a few scrapes but none the worse, at least going by the iShares S&P National AMT-Free Municipal Bond ETF (MUB). Somewhat troubling is the suggestion by the stellar bond manager, Jeffrey Gundlach of DoubleLine Capital, in a recent Barron’s interview that the municipal bond market is about to experience a much more severe decline:
He foresees a major collapse in the municipal-bond market, beyond the declines to date, given the parlous condition of both state and local government finances. He is preparing, he says, by having established a joint venture with the Chicago financial firm RiverNorth. Among other things, it expects to scoop up closed-end municipal-bond funds in the next year or so when the predicted apocalypse arrives, driving fund prices down, he says, to as little as 40% of net asset value.
What makes the $2.7 trillion muni market particularly vulnerable, Gundlach says, is its weak psychological underpinnings. Many investors in municipals are wealthy individuals who buy the securities purely because of their tax advantages and have little knowledge of the fundamentals of the paper they own. They tend to be “all-in” investors, owning little else, and thus will be prone to panic, he figures, in the face of surging defaults.
Look, I don’t know whether the market will suffer $10 billion or $30 billion in defaults, but the actual amount doesn’t matter, Gundlach says. “There will be a panic at the margin, and muni bonds from the highest-rated on down will plummet, in part because other sorts of investors tend not to step in.”
Gundlach doesn’t offer a timetable for this. But his propensity to be right both for major moves in the bond market and the equity markets characterizes him as an especially astute trader. It remains to be seen if his latest expectation will come to pass but before then, it is entirely possible for the municipal bond market to recover, even in a “dead cat bounce” to provide for a good exit from this opportunistic long trade.
In the meantime, the US government bond market looks to have carved out the intermediate low that I mentioned late last year and is ready to embark on a new rally higher.