Red Flags for Bonds?

01/20/2010 1:00 pm EST

Focus: BONDS

Mary Anne & Pamela Aden

Co-Editors, The Aden Forecast

Pamela and Mary Anne Aden, editors of The Aden Forecast, say Treasury bonds may be on the verge of a big change in direction, and rates could soar as bond prices plunge.

Interest rates have reached the moment of truth, and we should know the final outcome in the weeks just ahead.

The recovering economy, along with all of the monetary stimulus, is starting to fuel inflation concerns. Plus, the quantity of government bonds flooding the marketplace to pay for all of the additional spending is hurting demand for bonds.

So, interest rates are rising because bond investors are demanding that the government pay them a higher interest rate to keep lending the government money. That’s also why the yield curve has steepened to a record level.

With short-term interest rates being held near zero by the Federal Reserve and long-term rates rising, the spread between these two rates remains historically wide. This will not continue indefinitely. Eventually, short-term interest rates will rise, too.

Meanwhile, we’re seeing important early signs that the bond market has just about had it. If that’s the case, interest rates are going to soar. Here are the two most important signals we’re watching.

[A] two-year head and shoulders bottom [has] now formed on the ten-year yield. Based on technical analysis, the yield is pushing up against very strong resistance at 3.9%. If the yield is able to break above this resistance, then the odds favor a continuation of the rise.  By breaking clearly above 4%, the ten-year yield could quickly move up to near the 6% level.

Even more important is the 30-year yield, which [is] literally at a mega-crossroad. The mega-trend we’re watching is the 80-month moving average, which is currently at 4.64%, and the 30-year yield has been above or near this level for most of the past month.

The yield has only moved above or below this average very few times since 1930. And when it did, it marked the onset of a rise or decline in interest rates that lasted for decades. That’s what the “mega-trend” is all about. It’s super long-term, making it far more important than other shorter-term trends.

If the 30-year yield now stays above 4.64%, it will signal that a mega-trend change is taking place. This would be reconfirmed above 4.75%, and it would mean interest rates are eventually going much higher during this new decade. It would also be the final confirmation that inflation is going to soar, in an environment similar to the 1960s-1970s, but probably even more extreme, reinforcing what gold’s been telling us all along.

If that happens, it would be a huge red flag for bond investors as bond prices would drop sharply and we’d advise selling any government bonds you’re currently holding. This would also provide a great profit opportunity to short bonds, or to buy a fund that rises along with interest rates.

Remember, the two key numbers that’ll tell the story are 4% on the ten-year yield and 4.64% (especially above 4.75%) on the 30-year yield. As simple as this may seem, these levels are now more important than they’ve been in years.

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