Should You Buy Or Sell Bonds?
Weekly Notes With Tiho — Issue 3
Location: Ho Chi Minh City, Vietnam
Trump’s election win wasn’t kind to the Treasury market.
Initial clues of bond market weakness came in July of last year.
Writing for the old blog (Short Side of Long), I alerted my readers that Treasuries, together with other defensive sectors, were putting in a medium-term top.
Here is the extract from the post, which Market Watch picked up:
A range of asset classes have become “overbought, over-extended and prone to a correction” in the short and medium term, the Short Side of Long’s Brkan says.
He’s looking at you, long-duration Treasuries (EDV), TIPS (TIP), investment-grade bonds (LQD), gold (GLD) and U.S. REITs (VNQ).
By his thinking, much of this crowd is likely to fall in the days or weeks ahead. That’s because they’ve been “gapping upwards and lately moving in vertical fashion,” as shown in his chart above.
What’s more, their relative strength indexes have jumped above 70, and these plays are at least two standard deviations above their 50-day Bollinger Bands, Brkan says.
“Despite the fact that my portfolio has benefited tremendously, I now hold an opinion that we are about to mean revert,” the financial blogger writes in his latest post.
“I would advise my readers to be very cautious when it comes to adding new capital towards the overall bond market, real estate and precious metals sectors.
The call proved timely and correct.
Bonds went down.
The commercial real estate went down.
And gold also went down.
Since I actively manage my clients diversified portfolios, I was fortunate enough to be in an extreme underweight position with many of these “safe haven” asset classes, including bonds.
Bond Market’s Panic Attack
But then Trump’s election victory came along.
Let’s be honest.
Many of us did not predict that. Trump didn’t even predict that.
And neither did the bond market.
Trump’s policies were immediately viewed as highly inflationary. A downtrend in bonds intensified and all maturities from two year to thirty year crashed.
Adding fuel to the fire was Federal Reserve’s chatter of the up-and-coming rate hike in December.
There wasn’t a bond bull insight.
By the middle of December sentiment became most bearish in a decade.
Even more so than the 2013 Taper Tantrum.
Investors were so bearish on Treasuries that the only logical thing to do was turn bullish.
So I did. And I bought bonds.
Reasons For Bond Market To Rally
Investor sentiment isn’t the only reasons bonds should have a high probability of rallying.
Let me run you through a few more indicators I am currently studying.
Firstly, positioning by hedge funds and other speculators in the Treasury market has turned extremely net shorts in recent months.
Every Tom, Dick, and Harry is expecting and positioning for higher rates.
That means lower bond prices.
Historically, whenever speculators build high short bets, there is always a risk of a short squeeze — a powerful and sharp rally forcing these same speculators to unwind their bets.
Secondly, bonds have become oversold.
This is not just my opinion. You are observing 90 years of history here.
The peak to trough decline, also known by its technical name as a drawdown, has become quite extreme relative to its history.
Near the lows of mid-December, 10 Year Treasury Total Return Index was in a drawdown of more than 10%.
Glancing at the chart above, you should notice that it usually doesn’t get much worse.
Investors and hedge funds aren’t the only market participants that are negative on bonds.
The highest percentage of US consumer respondents since 2007, now expect rates to rise over the coming 12 months.
The public is notoriously wrong at major turning points.
Naturally, I’ve been wondering if this is one of those.
Finally, I’m also paying close attention to the spreads between Treasury yields and lower quality bonds.
After a stellar 2016 and a great first quarter of 2017, it seems that credit spreads are bottoming out.
Could we see another widening episode like 2015?
Are credit spreads too narrow? And valuations too rich?
If you think the answer is yes, holding Treasuries over Emerging Market Debt, or Junk Bonds would make a lot more sense.
Points listed above are just some of the evidence to be bullish on bonds.
Therefore, from a contrarian’s perspective, my client’s portfolio have been overweight bonds since the middle of December.
I’ve held a view that Treasury prices are basing.
Friday’s Bearish Reversal
Having said that, last Friday’s price action might be the next necessary clue to the important question:
“Should you be buying or selling bonds right now?”
I’ve noticed that all Treasury maturities did a nasty bearish reversal at or near major resistance levels.
It was also a false breakout.
My experience has taught me that a false break is usually a trap.
In this case… a bull trap.
It is a contrarian move that catches amateur traders off guard. These are the market participants that act on technical patterns and emotions only.
Could the bond market be expecting the start of Fed’s balance sheet reduction?
Will the Fed speed up its hiking cycle? Or maybe the ECB is about to end its QE?
With so many conflicting messages and indicators, both from the bullish and bearish perspective, it is important to keep a clear head.
Trading markets isn’t for the faint-hearted.
You need someone with expert skills to make tactical overweight and underweight portfolio decisions.
Someone with the ability to read the tape. And someone with the risk management mastery to protect your wealth in these volatile times.
If you would like to know how I am positioning my client’s portfolios in the bond market — get in contact by clicking below and filling out the brief survey.
I’ll get back to you within 24 hours.