A Head and Shoulders Pattern Could Develop for Bonds

 | Nov 27, 2017 | 6:00 AM EST
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Let's talk about bonds. I'm sure by now you have read and seen all the discussions on the yield curve and how low spreads have gone. For the longest time this year, before the spread between the yield on the two-year note and the yield on the 10-year note started to collapse, the cry of the land was, "I won't turn bearish until the yield curve goes negative."

The spread has gone from 1.0 percentage point to 0.60 percentage point since July. Can you imagine, if a stock market did that kind of move (up or down), the extrapolation that the trend would continue would be massive. Those comments we saw earlier this year about not turning bearish until the curve goes negative were at their height in July. If you look at the chart, you can see the rally into early July.

Let's take a closer look at the chart, with the caveat that I am the farthest thing from an economist, but I can -- or at least I think I can -- read a chart. What I see is a downtrend ... for the last year. I would think anyone who looks at this chart would agree. What we also see is that since early November, the decline has accelerated.

If you wanted to do a measured target from that pattern I have drawn (red line is the breakdown) we get 0.60 percentage points, which happens to be approximately where we are now. If we take a longer-term chart of this spread (not shown), we can come up with a downside measured target of 0.20-0.25.

But back to the chorus of those who say they won't turn negative unless/until they see it negative. That song has changed quite a bit in recent days. Now we see a list of "excuses" as to "why" the big move down in November. So now I suppose we are to ignore the fast plunge toward (possibly) going negative because, well, I guess it no longer supports their bullish views.

So let's get to the chart of (TLT) . Typically, I would look at the chart of rates on the 10-year note, but I feel the chart of TLT is a bit clearer to see. First of all, you can see the rise in TLT in November. This means those longer-term rates are going down (higher prices mean lower yields). What if TLT peaked somewhere in here and headed down (rates up, prices down), since there is a strong potential for this to be the right shoulder of a head and shoulders top?

I don't quite think we're there yet, though. Perhaps it needs a move where it gaps up and reverses (see June's left shoulder), but I think this is a chart to pay attention to. And of course, if the rates on the 10-year note shift, the narrative will shift as well.

As for the stock market, there is very little change, in my view, from Friday. The market is not yet overbought, so despite the fact that the big caps have begun to lead again, the market has a window to correct the divergences that are creeping in. I expect the market to reach an overbought reading later this week/early next week.

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