By Jim Barrett
I’ve been involved with the Treasury bond market since 1979, originally as a floor trader, and recall how bond trading was king back then.
However, the spotlight dimmed as the U.S. government began to get its fiscal house in order during the late 90s; so much that it was even able to run small surpluses, negating any need to issue 30-year Treasury bonds for a few years.
Things have changed since then – two stock market bubbles, a commodity bubble, a housing bubble and two wars. The macroeconomic situation has definitely changed in a very dramatic way. All of a sudden there is a need to issue a few 30-year bonds; actually a record amount of 30-year bonds.
The projected government spending over the next couple years has exploded to post-World War II highs, whether we are looking at outright supply, or as a percentage of GDP. The government is desperately trying to help the economy deal with the massive de-leveraging of all asset markets.
This massive tsunami of supply has shifted long-term fundamentals and it looks likely that the 27-year bull market in bond prices is struggling and possibly ending. There’s technical evidence that the historically low yields near 2.66 percent, reached in mid-December of 2008, will stand as extreme highs.
If you look at the weekly chart of the 30-year U.S. Treasury bond (below), there was an incredible breakout from the weekly congestion near 124 to approximately 142, an 18-point run.
The market has since unraveled in the first few months of 2009. This pattern appears to be a total rejection of those levels, indicating that a new trend has started. The actual top formation unfolded as a tight rectangle just before the holidays, as fears about general economic weakness were priced in the market. As participants looked to the new year, fears about exponentially growing supply for the next couple of years have influenced the market. The markets have been in a noticeable downtrend after breaking out of the rectangle, with a continuing pattern of lower highs, at the beginning of 2009.
There are a couple of questions that might have clarified this move for a trader. Number one, where is the weekly support? In other words, once the market broke the rectangle, what was a logical target? We can get a better perspective of this target by looking at the monthly chart, as seen below. November’s breakout from 124 was the same breakout area that had marked the bull market’s previous yield low, at 375, in 2003, the bottom of the bear market in stocks. With a wider perspective, the breakout makes more sense. The other question for the trader is whether or not you’re ready to take advantage of a move based on these potential breakouts.
Looking at the weekly situation, the 124 chart target has been accomplished, and interestingly, support has held very well. The multiple bounces off this support have been subdued, as the market braced for $63 billion of new supply that was auctioned off last week. It even held in the face of a huge bounce in the equity market.
To summarize, the market’s long-term fundamentals are indicating the derailment of the 27-year bull market. The rejection pattern from mid-December is hinting the same, yet monthly and weekly support levels are holding up.
China’s Treasury Concern
The tensions between sharply increasing supply, and the fact that the Treasury relies heavily on foreign purchases to fund the deficits, will keep this market volatile going forward. The recent unprecedented public row between the U.S. and China, the biggest holder of U.S. Treasuries, illustrates this tension.
Chinese Premier Wen recently called out to the administration about the deteriorating U.S. financial situation and conveyed concerns about holding Treasury instruments. The Obama administration felt compelled to refute accusation and responded by stating it intends to return the country to fiscal prudence once the crisis passes. Coincidentally, the respective countries’ navies were playing cat-and-mouse games on the high seas earlier that week. Five Chinese naval vessels basically surrounded the U.S. Impeccable, a sonar ship assigned to monitor activity in the South China seas. Our biggest creditor is definitely going to keep an eye on us going forward.
Of course, China is not the only buyer of U.S. Treasuries. The Japanese are the second largest holders, but are seeing their trade surpluses vanish as the U.S. consumer remains on the bench. The Russians and OPEC are also large buyers, but with the collapse of oil prices, they are facing a situation of less revenue needing to be recycled into U.S. Treasuries. It’s interesting that the Obama administration calls for energy independence, but there is no recognition that we cannot even be independent in funding our own government budget, now or in the future.
So, how do traders take advantage of the likelihood of volatility in these markets? The key thing is to define what time frame you, as a trader, intend to use in approaching the market. The cardinal rule is not to mix up investing with trading. After the big rejection of last year’s highs, we have a market doing some normal range trading, regardless of the big geopolitical headlines.
Negative vibes from China and the biggest weekly jump in stock indexes since November have not threatened the previously mentioned weekly support area. What could be keeping this market up in light of the heavy supply situation? We have to look overseas for one possibility, merry old England.
Bank of England Action
Over the last couple of weeks, the Bank of England has undertaken a successful (short-term anyway) qualitative easing that dropped yields on five year and longer Gilts back near last year’s lows. Apparently, the English economy is in very bad shape and therefore they’re the first to use this tactic. The central bank is basically goosing up its own bonds with heavy duty purchases, in this case, $2.8 billion worth in the open market. Short-term rates were already down to 0.5 percent, so the Bank of England felt it needed a new tool to halt the downward spiral in the real economy. Their goal is to halt deflationary forces and get inflation back to a positive level.
Understandably, the British pound took a hit, but prices of the debt securities leapt the biggest amount since 1989 on March 12 and 13, 2009. Yields dropped back to recent record lows. This crushed the bears and means real danger to bears in the U.S. bond market right now. The Federal Reserve has only discussed this sort of strategy in the past, but has also said that it is open to any ideas that may help our economy climb out of the hole.
Longer term, it’s hard to imagine such a policy will successfully keep long-term rates under whatever fundamental value is (absent of sustained buying by the central bank), but you sure don’t want to be short the first time they come in.
The big question is whether or not the Federal Reserve will be vigilant down the road, and prevent a resurgence of inflation if the economy eventually gets back on its feet.
Jim Barrett is a Senior Market Strategist with Lind Plus. He can be reached at 866-231-7811 or via email at jbarrett@lind-waldock.com. You can hear market commentary from Lind-Waldock market strategists through our weekly Lind Plus Markets on the Move webinars. These interactive, live webinars are free to attend. To sign up, visit http://www.lind-waldock.com/events. Lind-Waldock also offers other educational resources to help your learn more about futures trading, including free simulated trading. Visit www.lind-waldock.com.
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