Treasuries Set Up For Possible Reversal

Includes: IEF, TLT
by: Chris Ciovacco

There are three reasons to be open to a possible reversal in Treasuries:

  1. Valuations / near-record low yields
  2. Slowing momentum
  3. Better than expected outcomes in Europe

The fundamental problems in Europe are serious and the options for policymakers are limited. Therefore, it is understandable investors have flocked to U.S. Treasuries and German bunds. However, when there is a possibility of yields slipping into negative territory, you have to ask yourself how long current trends can continue without at least some corrective activity. From the Wall Street Journal:

For the first time, the two-year German bond yield may dip below zero, a rare occurrence in the global fixed-income universe and one that flags growing fears over the future of the euro zone. …Bunds and U.S. Treasury bonds have been the primary safe harbor, and the strong demand has sent yields, which move inversely to their prices, to record or near-record lows. The most striking manifestation of that this week is the two-year German bond's yield, which Wednesday touched a record low of 0.02%. At the same time, Germany sold a same-maturity bond with a zero coupon, basically allowing the nation to fund itself with almost free cash.

After rising for seven straight weeks, long-term Treasuries (NYSEARCA:TLT) dropped 0.64% last week. Similarly, the seven-to-ten-year Treasury ETF (NYSEARCA:IEF) recorded its first weekly decline in ten weeks. The markets appear to be trying to back off the "run for the risk exits" stance. From Bloomberg:

"Yields will stay low, but the Treasury rally is losing momentum," said Hideo Shimomura, who helps oversee the equivalent of $75.3 billion in Tokyo as chief fund investor at Mitsubishi UFJ Asset Management Co., a unit of Japan's biggest publicly traded bank. "European governments are defending the euro. That's the priority. The fear of the destruction of the euro will fade."

The slowing momentum in TLT is evident when examining the weekly chart. Since a picture is worth a thousand words, the video below compares the current charts of TLT and the euro (NYSEARCA:FXE) to the S&P 500's prior to the March 2009 bear market low.

While the situation in Europe can take numerous paths after the June 17 elections in Greece, recent history points toward policymakers and the European Central Bank (ECB) taking action should Spanish and Italian yields continue to rise. After the close on Friday, Spain announced a $24 billion bailout for Bankia SA, effectively nationalizing the country's third largest bank. Spain's action fits the pattern of using public funds to keep the system propped up. The odds are better than average if things do not go well in Greece or Spain, the ECB will act as the lender or buyer of last resort, which could prompt selling in U.S. Treasuries.

From a tactical perspective, the table below can be used to monitor the health of the current rally in conservative assets. As long as TLT and the U.S. dollar ETF (NYSEARCA:UDN) hold above the support levels in the table below, the bulls will still have the upper hand. If these levels give way, it will add to our short-term concerns about Treasuries.

If you own TLT or IEF, another relatively easy way to monitor the health of the current rally is to keep an eye on the daily MACD. A bearish cross occurs when the black line drops below the red line. The negative slope of the black MACD line below (see red arrow in chart below) is indicative of slowing enthusiasm from Treasury investors.

As you can see, MACD has experienced a bearish cross on the daily chart of IEF below.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.