Is It a New Dawn for the Bond Market?

02/10/2011 4:20 pm EST

Focus: ETFS

Thomas Aspray

, Professional Trader & Analyst

China’s latest rate hike and a break of a major technical level could mean we're on the cusp of a whole new era for bond investors and traders.

Most members of the financial community were expecting the People's Bank of China to again raise rates, and probably the only surprise was that the decision came before the Chinese stock market reopened after the lunar New Year. As demonstrated by their two previous rate hikes, the Chinese are very concerned about inflation. The initial reaction of the Asian stock markets was negative, especially in Hong Kong, but so far, the US and euro zone markets have shown little reaction. Is the Chinese rate hike significant for our markets?

Figure 1

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This was going to be a pivotal week in the bond markets even before China's rate hike. Last week, the long-term downtrend in 30-year Treasury yields (line a) was broken. Yields are higher again this week, and a close above the early-April peak at 4.86% will start a new uptrend as the chart will have formed higher highs and higher lows. If yields rise as much as they did from the 2008 lows to the 2010 highs, the Fibonacci equality projection is for the 30-year yields to rise to 5.83%.

Figure 2

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The weekly chart of the ten-year note yield gives us a better idea of where US yields were when the Chinese cut rates and what happened afterwards. Though there are not enough data points to draw any conclusions, the rate hikes in China did coincide with some of the turning points in the US. For example, during the week ending December 8, 2008, yields ranged between 2.76% and 2.54 %, closing at 2.59%. Yields declined the following week to a low of 2.04% before starting a 16-month rally back to a high of 4.01% in April 2010.

What About the Most Recent Rate Hikes?

The yield on the ten-year note bottomed at 2.33% on October 8, 2010, and it was at 2.48% on October 19 when the People's Bank of China raised rates. Yields have been rising quite sharply since, but paused briefly before the December 27 rate increase. The three-year resistance at 3.72%, line b, is now being challenged. If the current rally in yields is of the same magnitude as the 2008-to-early-2010 rally, then the equality target for ten-year yields is at 4.13%. This is not far from the multi-year downtrend (line a), which is currently at 4.20%. Therefore, it is possible that the long-term downtrend on the ten-year yield will not be broken on this current rally, so rates could have several swings this year. The chart has further resistance in the 4.50% area.

Figure 3

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The quarterly chart of the T-bond futures (using a continuous contract) shows how incredible the rally in bonds and the decline in yields has been from the 1981 and 1984 lows. This major trend line is currently at 110 with the parallel uptrend from the 1994 lows just a bit higher at 113.50. (The futures actually trade in 32nds.) 

Figure 4

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The weekly chart of the T-bond futures formed a "gravestone doji" at the end of August (see chart), which is quite a negative candle formation. As I commented at the time (see Are Bonds Finally Topping Out?), this is a candle formation often seen at major tops as the market moves high enough to entice the last buyers before trapping them in at that high price.

The T-bonds declined into mid September and then rebounded into early October, peaking at 135.34, well below the prior peak at 136.84. The weekly on-balance volume (OBV) did not form any divergences at the highs, while some of the other momentum studies, like the MACD-Histogram, did. The weighted moving average (WMA) of the OBV started to roll over in late October, and the uptrend, line c, was broken the week ending November 6, 2010. Capital started moving out of the bond market over the next two weeks, which was in contrast to the massive inflows into bond funds of the past few years.

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Figure 5

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The iShares Barclays 7-10 Yr Treasury Bond Fund (IEF) completed a nice head-and-shoulders top formation on November 12 when the neckline (line a) was broken on a closing basis. This was over four weeks after the Chinese rate hike. There was a brief bounce from support at $96.50, which was a good chance to get out, as the next wave of selling was heavier. The daily OBV formed a negative divergence at the highs, line d, as it failed to make new highs. No divergences were observed in the weekly OBV. In December and early January, IEF formed a classic continuation pattern (noted in red) that set the stage for the recent plunge as it dropped from $93.70 to the $91 level in a matter of days. Prices are now reaching the former downtrend, line b, and there is long-term support at $89. The daily OBV shows no signs yet of bottoming, so any rebound due to the high bearish sentiment is likely to fail.

Figure 6

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The iShares Barclays 20+ Yr Treasury Bond Fund (TLT) has not fared any better. The weekly chart shows the same gravestone doji at the end of August as it corrected from above $109 to below $101. The rebound into early October just retraced 61.8% of the decline, and the sharply lower close the week of October 12 (see arrow) gave a strong sell signal. The weekly on-balance volume dropped below its WMA in September and failed to move back above it in early October. As I have mentioned in earlier articles, this is a very negative development. The uptrend in the OBV was not broken until November, and it has continued to make new lows. There is multi-year support in the $85 area, but it may not be tested for some time since the daily studies are oversold.

Selling the TIPS and Buying Junk

Figure 7

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Given the sharp decline in the Treasury Inflation Protected Securities (TIPS) ETFs, like the iShares Barclays TIP Bond Fund (TIP), investors are either not worried about inflation, or more likely, they're unhappy with the current low yield of 2.47%. The weekly support at $105.40 (line a) could be broken this week, putting anyone who bought this fund since last May in the red. There is some support in the $104 area and major support at $102.40, line b. The weekly OBV broke its uptrend soon after the rate hike, so perhaps some investors were convinced that future inflation was no longer a problem. The OBV recently rebounded to its weighted moving average, but is now declining once more, which does favor a further decline.

On the other hand, the high yield (read "junk bond") ETFs, the iShares iBoxx High Yld Corporate Bond Fund (HYG) in this case, remain in a shallow uptrend as investors continue to like its current yield of 8.48%. The weekly technical studies are positive with the OBV well above its highs. Nevertheless, the chart pattern makes me nervous. I would not be surprised if one sharply lower weekly close completed a significant top. HYG had a wide range on Wednesday (Feb. 9) and closed sharply lower on heavy volume. This could be the start of a more serious decline. There is short-term support at $91.30 and stronger support at $90.74. A break below the weekly support at $88.32 would complete a top formation. Too bad there isn't a short junk bond ETF because there may be an opportunity there.

Figure 8

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From a technical standpoint, the ProShares UltraShort 7-10 Year Treasury ETF (PST) looks better than the ProShares UltraShort 20+ Year Treasury ETF (TBT). The daily chart shows that PST just completed a nice continuation pattern (lines a and b) last week as it gapped to the upside and moved through its short-term downtrend. The 50% retracement resistance now stands at $45.40 with the 61.8% resistance at $47.20. If the rally from the lows at point 3 is equal to the rally from point 1 to 2, the 100% equality target is at $48.20. The weekly technical studies are positive and have been since November. This suggests that an important low may be in place. The daily OBV has confirmed the recent breakout and is holding above support (line c) and it's weighted moving average. I would buy PST on a pullback to the $42.90-$43.34 area and place a protective stop at $41.36. If filled, I'd raise the stop to $42.90 on a move above $44.60 and sell half the position at $45.21 to lock in profits.

It does appear that the most recent interest rate hike by the People's Bank of China coincides with an important turn in the US market; that being the breaking of the long-term downtrend in 30-year bond yields. Since the T-bond futures topped in August, I cannot say that their action is a leading indicator, but more likely a confirming one. Over the next few months, we should get further evidence to support the view that the 30-year bull market in bonds is really over. If this trend has changed, it will require investors to adjust their portfolios accordingly. Though stocks may initially react unfavorably to rising rates, it should be bullish for the intermediate term. Traders should also have many opportunities in an environment where rates are rising, rather than falling.

Tom Aspray, professional trader and analyst, serves as senior editor for The views expressed here are his own.

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