Is the Bell Tolling for Bonds?

Last week was pretty scary in the bond market.

Three auctions—of two-, five-, and seven-year Treasuries—flopped, as buyers, especially foreign investors, sat on the sidelines.

That triggered a huge sell-off in Treasuries, the world’s most liquid fixed-income market.
Yields, which move in the opposite direction from bond prices, soared.

The yield on 30-year Treasuries briefly came within a hair of 5% before settling back to the 4.75% range. The ten-year note’s yield hit 3.9%, driving 30-year mortgages, which are priced off that ten-year note, over the 5% mark.

All these rates are much, much higher than they were back in December 2008, when bond yields hit generational lows.

The poor auctions and subsequent dumping of bonds set off all kinds of alarms. Is inflation right around the corner? Are foreign holders of US debt, the people we’ve counted on to keep financing our ballooning deficit, finally saying, no mas? And is our low-interest-rate Nirvana gone for good?

My answers to those questions are: no, probably not, and probably.

I don’t think inflation, especially hyperinflationis anywhere on the horizon. And I don’t believe foreign buyers are giving up on US debt—for many of them, it’s practically the only game in town.

But in the wake of the crisis in Greece; rumblings about Portugal and other European countries; worried noises by rating agencies about the creditworthiness of the United Kingdom and the US, and last week’s signing into law of President Obama’s mammoth health care reform bill, foreign and domestic buyers may well demand higher interest rates to compensate them for the perceived higher riskof owning US government debt.

Last week’s big surge in rates is also getting the attention of some savvy technicians who think we could be at a major turning point for bonds. 

Pamela Aden, who with her sister Mary Anne edits the Aden Forecast, a technically-based advisory service that follows big trends in stocks, bonds, commodities, and currencies, says bonds are threatening to reverse trends going back nearly three decades.

She cites the following chart (reprinted courtesy of the Aden Forecast), which traces the yield of the long bond back to the Depression year of 1930:

Click to Enlarge

As you can see, the yield on the 30-year Treasury peaked above 14% in 1981, then started a steady decline to its late 2008 low of 2.6%. It’s rebounded since then, along with the economy and the markets, as fears of financial collapse faded.

But notice the dotted line on the chart, where the 80-month moving average sits. A moving average is simply the average of all readings for a particular data point over a certain period of time. Aden says the 80-month moving average captures long-term trends—in this case, lasting nearly seven years.

That key moving average is at 4.65%, which the 30-year bond decisively broke last week. Aden sees that and the 4.75% level slightly above it as critical markers for the future of the bond market.

“If the 30-year bond would stay over 4.65%—and especially 4.75%—that means we’re heading for higher rates,” she says. “We feel we’re getting close to a megatrend change in interest rates.”

The yield on the 30-year Treasury closed above 4.65% for the last six trading sessions, and above 4.75% for four of those days. (It closed Wednesday at 4.72%.) Aden would like to see it stay above 4.75% for two weeks to confirm this “megatrend change.”

John Carter is also watching Treasuries closely. The president of Trade the Markets has been looking for a breakout in yields on the ten-year Treasury note for some months.

“If we can move up to 3.9% [in the ten year,] that would signal a break in the trend line,” he says. “All the indicators I’m looking at indicate they’re going to push through.”

The ten-year closed at 3.9% last Thursday and has hovered above 3.8% for a week.

When we spoke late Wednesday, Carter told me he owned put options on the ten-year and also the popular UltraShort 20+ Year Treasury ProShares (NYSEArca: TBT). That’s a volatile exchange traded fund that is supposed to move twice as much as Treasury prices, though in the opposite direction. It’s only for sophisticated traders and risk-tolerant investors.

“I’m looking for interest rates to get near 6% by the end of the year,” he says. Why?
“It’s the foreigners’ appetite for our debt—nothing to do with inflation, more to do with the [weakening] position of the US.”

“Now the technicals are catching up with” the fundamentals, he adds.

Not so fast, says economist Gary Shilling, editor of INSIGHT.

“What you have now is absolutely no different from what you’ve been hearing for 30 years,” says Shilling, who has been on board for almost the entire bull market in Treasuries.

“I’ve been a bond bull since 1981, and every step down I’ve heard it can’t go any further,” he recalls. “The marvelous thing about everybody involved in Treasuries, virtually everybody hates them. Whatever it is, it’s doom or gloom.”

Shilling actually told his subscribers to sell bonds in 2008, just about when the long bond hit its 50-year low of 2.6%. Yields have crept back up since then, of course, but Shilling actually expects them to move down again.

“I think it’s going back to 3%, but that’s obviously based on my prediction for deflation,” he says. “At 3%, the bond rally of a lifetime is over.”

Whether bond yields start rising again matters a lot—to American taxpayers who will have to shell out ever-higher interest expenses to finance our bloated deficits; homeowners, who may have to pay sharply higher rates when their adjustable-rate mortgages reset, and US investors, who poured $375.4 billion into bond funds in 2009 in a flight from risk and a quest for decent yields. Remember: When rates rise, the value of their bond fund holdings goes down.

And once rates start rising, they could head higher for a long, long time. Take a look at the Adens’ chart again: Before their three-decade plunge, bond yields had been rising since 1941—a stretch of 40 years!

I don’t know if that’s in the cards. But I know one thing for sure: A sustained, long-term up swing in Treasury bond yields isn’t priced in to the stock market now. So, a sharp rise in yields could bring a nasty surprise for stock investors, too.