U.S. government-backed bonds and notes finally turned the corner in early February; despite a late February bounce, we continue to believe the path of least resistance will be lower. A primary fundamental argument for bond bears (and therefore yield bulls) is higher Fed funds rates at the hands of an eventual Federal Reserve target interest rate hike. In addition, a reduction in global safe haven buyers and chatter of inflation worries in the Eurozone should work against the Treasury market bull.
Similarly, the previous two employment reports have been much stronger than even the optimists had anticipated; should Friday's release corroborate an improving job market, it will be difficult to sell the idea of "return of capital" over "return on capital" to investors. At current dismal yields, Treasury bonds and notes represent the former, not the latter.
Although we tend to focus our analysis on the futures markets, a rare anomaly in the 30-year Treasury bond market caused a massive jump in pricing between the March and June delivery contracts. This leaves us looking to the iShares 20+ Year Treasury Bond ETF (TLT) chart for overall directional bias. If you are unaware of the situation in the long bond futures market, and are interested, here is an explanation:
Because the U.S. Treasury opted not to issue 30-year bond securities from 2001 through early 2006, there is a gap in the deliverable underlying bonds for the futures contracts (bond futures trade similar to an index that represents the cheapest to deliver Treasury bonds). Simply put, the gap in issuance results in a gap in deliverable securities. Because the "cheapest to deliver" are typically the quickest to expire, this gap causes the June futures contract to have a longer duration (more price sensitive) and to have a significantly higher price (although the yield is similar to the March contract). The higher price is the result of the fact that there was a significant change in interest rates during the five-year issuance gap; thus, the coupon yield paid on the securities deliverable against the June futures is much higher relative to that of the March. To compensate, the June futures price is nearly 14 full points higher.
Those trading bond futures, and options on futures, will likely benefit from looking at the TLT chart for a long-term prognosis on pricing. In January, we wrote a piece on Treasuries expecting prices to peak and reverse. Our initial thought was about $135 in the TLT would be the ceiling, but at the time we couldn't rule out an inexplicable spike to the $139 area. As we now know, $139 was in fact in the cards, but prices were unable to hold at such extreme levels. Since then, prices have retreated rather sharply.
The path markets travel is rarely a straight line, therefore large bounces are to be expected. Nevertheless, we believe the current environment should be treated with a bearish bias for the time being. Specifically, the weekly TLT chart is projecting the current decline will extend into the $123 area. Further, should the Fed begin to take action and investors shift into liquidation mode, a dramatic plunge toward $110 is plausible.
Converting this analysis to the June futures chart, the $123 target in the TLT is equivalent to the mid-$154 area in the ZBM15. Additionally, the $110 TLT target should land the ZBM15 near $138! Clearly, such a move won't happen overnight, but it is something to keep in mind as you navigate the markets in the coming months, or years.
From a seasonal perspective, Treasury selling does tend to dry up in late March. In fact, the market is inclined to give the bulls an edge in April and May. Thus, even if we are correct about the long-term trajectory, there will be some challenging moments for the bears.
Aside from technical and fundamental factors favoring the bear camp, there could be some logistical issues as well. According to a recent Wall Street Journal article, bond ETFs are experiencing historic inflows of capital as institutional and retail investors put money to work in the more convenient ETF market rather than traditional mutual funds. The convenience of quick buy and sell opportunities and lower transaction costs are the primary lure. However, there is also conventional theory suggesting that although ETFs offer substantial market efficiency, they might also promote bandwagon trading and exaggerate panicked selling.
Further, unlike a mutual fund in which liquidation of a holding must be done at the end of the trading day, ETFs offer the opportunity for investors to place stop-loss orders. Anybody who has been around speculative trading for any length of time knows that mass exodus by investors is almost always embellished by stop running.
In conclusion, we believe the aforementioned fundamental, technical and logistic factors are compelling reasons to proceed with a bearish bias in Treasuries.
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