Schaeffer's Trading Floor Blog

Have Bonds Peaked?

Taking a closer look at the bond market

by 7/17/2012 3:43 PM
Stocks quoted in this article:

Earlier this year, investing in the bond market was considered borderline criminal by many market participants. Equities were rallying sharply during January and February, and putting money to work anywhere but equities was a good way to lose money on a relative basis. Many were calling for a bubble in the bond market itself, declaring that the level of low yields we've experienced for some time would be impossible to sustain. As whole, sentiment within the bond market was abysmal.

Fast forward five months, and we are currently sitting with bond prices near their highs of the year. Yesterday, the iShares Barclays 20+ Year Treasury Bond Fund (NYSEARCA:TLT) hit a new intraday all-time high, but prices reversed sharply after journeying into new territory. What's even more interesting than the price action within the bond market is the dramatic shift in sentiment. Many market pundits are calling for yields as low as 1% by the end of the year (the 10-year note is currently yielding 1.5%). For those of you unfamiliar with the bond market, bond prices are inverse to their yields. So, a low yield would result in a high bond price, and vice versa. Below, you can see the extreme moves that have been made in bonds just in the past six months.

Click to Enlarge
Chart courtesy of StockCharts.com

Looking at a daily chart of the TLT at present time, you can't help but notice what appears to be a double top forming. Technical analysts would point to the last two days' price action as a high probability reversal point, with yesterday's evening star candle being followed by another significant move to the downside today. Another factor to consider is that this occurred near the psychological 130 level, which happens to coincide with a round 1.5% yield level. Virtually all assets tend to reverse near key round number levels, and 130 could be it for TLT.

The last piece of evidence that compels me to try to pick a top (which is typically a losing proposition when trading, as the trend is your friend) is a recent Barron's cover with the title "What's the best bond fund for you?" At Schaeffer's Investment Research, we love to use magazine covers as contrary indicators to general public sentiment. The fact that "the herd" has flip-flopped from calling for a bubble in March to deciding which bonds to buy is a key factor to consider when analyzing the strength of this market. The crowded short position in bonds earlier this year has seemingly turned into a crowded long position. As Humphrey Neill states in his classic book The Art of Contrary Thinking, "The crowd is most enthusiastic and optimistic when it should be cautious and prudent." In this case, we feel that bond longs could be caught "offsides" here and now, creating an excellent risk/reward opportunity on the short side of the market.

By no means is this an "all in short" signal for bonds, but there is a good chance that we could have reached at least a short-term top. Trading is about putting probabilities and a favorable risk/reward setup in your favor, and there is currently a good opportunity to fade this recent rally. When entering a new position, you must have a "stop" level, or an area where you will exit and admit that your view was wrong. In this case, a break to new highs would signal that my thesis is incorrect, and exiting the position would make sense.


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