Investors flocked into long bonds ever since the Federal Reserve raised rates 25 basis points in March. The iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT) rose over 10% from 116 to 127.90 over the last three months. Many of these bond traders anticipate a slowdown in the economy and even a recession. Despite the weaker economic numbers, there will most likely be a better time to buy bonds.
As the stock market climbed higher earlier this year, investors expected a few more rate hikes. Investors drove the 10-year yield to roughly 2.625 and the 30-year yield to 3.20. While these speculators sold off these long-dated bonds, the commercial hedgers(smart money) established a very net long position in the 10-year bonds. Compared against the last two decades, the commercials were the most net long ever in January and February (644K contracts net long in January and 594K contracts net long in February).
The commercials most likely bought bonds earlier in the year as they priced in slower economic growth. Although the stock market boomed under the first few months under President Trump, the economic data failed to deliver the same results. Q1 GDP grew at 1.2%, while previous estimates called for higher growth. In May, the economy created138,000 jobsvs. 181,000 jobs created per month over the last year.
On the other hand, the non commercials or managed money (dumb money) took the other side of trade for the 10 year bond. Compared against the last two decades, these investors were the most net short ever (409K contracts short) in late February. They decided to short the bonds close to the top, and now bonds have rallied.
Ironically, non-commercials are positioned in a very bullish manner. Compared against the last nine years, these trend traders are extremely net long at 345,172 contracts. A month back, they were net long 362,501 contracts, which was the most net long since 2009. Although this may not be the top in the bond market, the non-commercials sentiment towards bonds is suspicious.
Several investors have jumped in the bond market rally due to the negative news, and it appears they may regret buying at these levels. Despite the negativity, the U.S. economy is not in a recession. A recession is defined as two GDP quarters of negative growth and we are currently nowhere near that.
Another manner to diagnose whether the economy is in recession is by looking at the yield curve. In a growing economy, long-term rates are greater than short-term rates. When short-term rates are higher than longer dated interest rates, this means that there is stress in the economy. Banks usually invest in long term illiquid assets, and they fund their operations by short-term liquidity. This system only functions when short-term rates are less than longer term rates. If short-term rates do go higher, then the banks lose money. Asset bubbles tend to burst as they did in 2000 and 2007 when the yield curve is negative. This inverted yield curve has a solid track record as it has predicted the last seven recessions. Currently, the yield curve is positive as the Fed funds rate is 1-1.25% and the 10-year rate is around 2.16.
Although the economy is slowing down, the market may have priced this information. Gloom and doom headlines are coming back, and everyone now wants to buy bonds. The reality is that the smart money is now selling the 10-year bond, and dumb money is aggressively buying. We are not in a recession yet, and buying bonds may not be the wisest investment at this moment.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am shorting bullish put spreads for bonds in the futures market.