Treasuries Rally as Riskier Assets Begin Showing Signs of Topping

Includes: GLD, SLV, SPY, TLT, UUP
by: Bill L.

I have previously made a contrarian case for the dollar approaching a bottom and stocks and commodities nearing tops. Continuing on that theme, I also wanted to look at the bond market as well as update the status on the dollar, commodities, and the stock market

First let's take a look at the TLT, a proxy for the long bond.

From this chart we can make several observations. First, we can see treasuries (bars) rallying as investors flocked to safety in anticipation of carnage in the stock market (SPY yellow line). We can also see that the bond market then begin to decline approximately 2.5 months before the stock market began to rally, and did not make a new high in early March. This non-confirmation of the March low in stocks was in fact foreshadowing the current rally in equities. Now the TLT may be signaling something else; after making a low on a spike in volume (which often signals an important trend change) the TLT has been rallying for about 2.5 months. This is interesting for two reasons. First, treasuries are typically seen as a “safe” investment, so that fact that treasuries are rallying with stocks (risky assets) is curious. Second, there has been much talk of rampant inflation as the economy begins to recover, and inflation typically destroys fixed income investments such as bonds. So in summary, bonds have been rising despite apparent increasing risk appetite for stocks, and inflation fears.

I would also mention that this type of behavior, bonds rising despite good gains in the equity markets has occurred before. For example, let’s look at the all time highs achieved in 2007. The SPY is represented by the yellow line, the TLT by bars. The bond market seemed to sense the impending danger and had been rallying for months before the stock market finally succumb to the credit crisis.

Dollar Close to a Bottom:

In my last article I made the case for the dollar finding a bottom. I believe the media has greatly exaggerated the probability of inflation in the near future. The Fed does not actually print money, but increases credit. While this can be inflationary as dollars multiply through loans, this requires the public to borrow, and the recent numbers show that consumer borrowing is down, and consumer credit is being drawn in.

On the technical side momentum in the UUP (dollar bull ETF) has been showing some divergences as the dollar approached a zone of support. Furthermore, bullish sentiment (daily-sentiment index) has reached as low as 3% and remains at prerequisite levels for a major reversal. I would also note that despite two years of the “printing presses” going, the dollar has basically not made any downward progress past previous lows, despite the expansion of the monetary base.

We can see from the chart that despite several consecutive lows, that these lows have not been confirmed by momentum. This indicates that the strength of each selling wave has been declining. While the dollar has breached the first firm level of support, surprisingly the uptrend in momentum remain intact. In aggregate sentiment, the zone of support, momentum, and the confirmation in the bond market are all strongly implying that the dollar should find a major bottom in this zone.

Gold Takes Another Run at 1000

Gold has edged higher as the dollar broke the first level in the zone of support we discussed. Gold is now entering a zone of resistance that it has failed to penetrate five times in the last two year. The residual strength index does not indicate that this current attempt has any stronger momentum than previous rallies. Furthermore, sentiment in precious metals is very high, at requisite levels for a major top. In the context of extreme sentiment, only par momentum, and a tough zone of resistance, gold may run a bit higher but I am not expecting a large break out.

I would note that a clear break above the zone of resistance could be interpreted as a break out from a very large triangle pattern. A breakout above this zone with confirmations will change my view, but buying in anticipation of a break out is in my opinion, the HIGH risk move.

Silver Continues Higher

Silver has been entering the zone of previous highs as the dollar has begun entering its zone of previous lows. This zone is very large, making a break out play much tougher, but as it stands I do not expect silver to break above these levels. My reasoning being that while prices have advanced the backdrop looks very challenging to future increases in price. Momentum does not confirm the price action. Furthermore sentiment is at very high levels, in fact registering highs over 90% bulls in the daily sentiment index, and like gold, the extreme sentiment levels lead me to believe that there are relatively few bulls left to drive up prices further.

The Stock Market: alas all good things…

The run in the stock market has been one for the record books, however the mantra is buy low, sell high and after a record 50%+ rally in 5 months, the stock market is starting to look tired. While the uptrend remains very much intact, there are a mounting number of red flags. These include the following.

Volume: As stocks are approaching a gap which should act as a very strong zone of resistance, we have seen one of the most persistent declines in volume in history. Typically, you would want to see volume expanding during a rally, and when volume is declining during a rally, this casts doubt on its sustainability. Furthermore we have started to see a pattern of low volume up days, then large volume down days. This is illustrated in the graph below by the large spike in selling volume, breaking the declining volume trend. Furthermore, as I mentioned in previous articles, trading volume in the NYSE is dominated in shares of Citi (NYSE:C), AIG, Fannie (FNM), and Freddie (FRE), and other companies that only exist today because of massive government intervention. Money chasing a relatively small, select group of highly speculative issues indicates that this trend is in its later stages.

Momentum: Momentum indicators are also diverging from the trend, we can see here that the RSI has begun to diverge and trend lower despite higher highs in prices. While this is not an action signal in of itself, it is another red flag.

Breadth: This divergent behavior is also clear in the McClellan Summation Index, which shows three clear lower highs, despite three higher highs in prices.

Sentiment: Sentiment has also reached extremes with a reading as high as 89% in the daily sentiment index. To put this into perspective, in October 2007 when the stock market made an all time high, the daily sentiment index recorded of high of 88%. Mutual fund cash levels are implying that fund managers are also very bullish; cash levels have again dropped to the record low level of 3.5% (where cash levels where in 2007 when the market peaked).


Treasuries have begun to rally despite good performance in risky assets. Historically when they disagree the bond market is usually proven correct; a negative for stocks. Furthermore the dollar looks set to bottom while stocks and commodities beginning to show signs of topping. All asset class have been trading with a historically high degree of correlation, so if the dollar does indeed bottom here, this will negatively affect stocks and precious metals. Sentiment is probably the best stand alone indicator for predicting an area where a major reversal will occur; dollar sentiment is at record lows, while sentiment in stocks and precious metals are at record highs. All these observations occurring together paint a very cohesive picture that risky assets are near tops, and value is now in cash and treasuries.

Disclosure: Long SPY puts.