Are Fears Of A Bear Market In Bonds Greatly Exaggerated?

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Includes: DLBL, DLBS, EDV, SPTL, TBF, TBT, TLH, TLT, TMF, TMV, TTT, TYBS, UBT, VGLT, VUSTX, ZROZ
by: Matthew Yates

Summary

Bill Gross calls the beginning of a bear market in bonds, others disagree.

Strong demand in recent U.S. Treasury auctions has led some to dismiss fears of a bond bear market.

The long term charts of bond rates indicate bearish risk remains.

Investors may be wise to exit the U.S. Treasury bond market and perhaps consider opening short positions in the near future.

The aging bull market has been kept alive through artificial means, and the death of the bond bull will be a shock to the financial system.

In a tweet sent out this week, famed bond investor Bill Gross stated:

Bond bear market confirmed today. 25 year long-term trendlines broken in 5yr and 10yr maturity Treasuries.

Bill Gross was referring to the same multi-decade trend line on the 10-year Treasury rate chart that was published in my previous article "Treasury Yields Point to a Looming Bear Market in 2018" written two weeks ago. I've updated the chart here to include the last two weeks of trading data:

(image courtesy of stockcharts.com)

The above chart has daily rate data from 1988 to 2018 and the downward trend is readily apparent. Since 1988, the 10-year Treasury rate has risen above this trend line only two times. The first was in 2007 for a brief period of time immediately before the financial crisis. The second time has been in the past few weeks.

The most recent break above the trend line can be seen more clearly by focusing on the past 12 months of data:

(image courtesy of stockcharts.com)

In the final two weeks of 2017, rates rose above the trend line, then retreated back to touch the trend line. The arrow on the chart above shows where the rates bounced off the trend line at the beginning of 2018. I assume that is was this bounce off the trend line that led Bill Gross to conclude that the breaking of the long term downward trend was confirmed, and a bear market in bonds has begun.

Given his extensive track record of successful investing in the bond market, the opinion of Bill Gross carries a lot of weight. However, not everyone agrees that a bear market has begun. Matthew Hornbach and Guneet Dhingra of Margan Stanley announced this week in Jedi mind-trick fashion:

Don’t worry, Treasuries continue to offer value. This isn’t the bear market you’re looking for.

Jeffrey Gundlach of DoubleLine Capital stated that Bill Gross was too early in his bear market call and points to a 3% yield on the 30-year Treasury as a key level that has not yet been broken. Kit Juckes of Societe Generale wrote that he does not believe a bear market in bonds has started until the rate of 10-year Treasury Inflation-Protected Securities rises above 1%.

Adding credence to the case for a continued bull market is the strong Treasury auction results this week. There was heavier than expected demand for 10-year Treasury notes auctioned on January 10. Demand was again strong on January 11 for 30-year Treasury notes. For the latest auction, 72% of the demand came from indirect buyers, the highest level in more than a decade. There are two ways of looking at the reasons for the high demand at the Treasury auctions. For the bullish case, the high demand is from investors looking to buy bonds at bargain prices due to the recent rise in yields. On the other hand, a bearish case may be made in that the spike in demand at the auction is a result of a short squeeze. The spike in demand will likely be transient if it is primarily from buyers covering short positions. Whatever the reason, the strong auction demand has caused rates to decline modestly, leading Kit Juckes to tweet:

30yr yield yields now 8bp off yesterday’s highs. The ‘new bear market’ crowd thank you for playing.

The problem is that investors are looking at day to day price movements in light of market trends that have persisted for decades. The only way to gauge the importance of recent bond price movements is to look at them relative to the long term trends. In the case of the 10-year Treasury rate, the strong auction this week did lead to a slight dip in rates. However, this has done nothing to invalidate the conclusion drawn by Bill Gross. The bull market trend has been broken. The 10-year treasury rate needs to fall below 2.4% to get back below the bull market trend line. That does not appear likely to happen any time soon.

What about the 30-year Treasury rates referred to by Kit Juckes and Jeffrey Gundlach? Here is a chart of TYX, the 30-year Treasury yield index, from 1988 to 2018:

(image courtesy of stockcharts.com)

Unlike the 5-Year and 10-Year rates mentioned by Bill Gross, the 30-year Treasury rate is still clearly following the bull market trend. The recent dip in rates following the latest auction is nothing more than noise on this longer term chart. By my estimate, 30-year Treasury yield would need to rise to near 3.1% to break this trend line.

The fact that 30-year Treasuries still appear to be in a bull market should not reassure investors. Shorter term Treasury rates are continuing to increase. As already mentioned, the 5-year and 10-year Treasury rates have decisively broken above long term trends. In addition, the 2-Year Treasury rate has been increasing exponentially for the past 6 years:

(image courtesy of stockcharts.com)

As long as the shorter term rates continue to rise while the 30-year rate continues to fall, the yield curve (the difference between longer term and shorter term Treasury rates) will compress. A decline in the yield curve historically indicates a slow down in the overall economy.

Compression of the yield curve will not continue indefinitely. One has to assume that either short term bonds are oversold or the 30-year bond is overbought. Given the fact that rates across the board are far below historical norms, it seems far more likely that the rate of the 30-year Treasury bond is overdue to rise. The recent 30-year bond auction has done little to make a bullish case. Consider this chart of the 30-year Treasury rate plotted from 2013 to 2018:

(image courtesy of stockcharts.com)

I have drawn three horizontal support and resistance lines on the above chart. A bullish case for the 30-year Treasury could not be made from this chart until rates have dropped below the lowest support level at about 2.7%. As mentioned previously, a rise to about 3.1% would clearly break the multi-decade long downward trend in rates for the first time since 1988. If rates rise above the middle resistance line at about 2.95%, breaking the trend line becomes a real possibility. The charts show that there is a greater risk for the 30-year Treasury yield to rise than to fall. It is likely only a matter of time before the 30-year Treasury charts signal the onset of a new bear market, as the 5-year and 10-year Treasury charts are already signaling.

The bull market in bonds is unprecedented. One of the main reasons that the bull market has survived as long as it has is the intervention of central banks throughout the world. The attempts of central banks to normalize their balance sheets will bring downward pressure of bond prices. The onset of a bear market is only a matter of time, and we are far closer to the end of this bull market than the beginning. Now is the time to lock in gains on holdings of TLT and other bond investments. Bill Gross has already opened short positions in the bond market. It may be a good time for other investors to consider following suit. The aging bull market has been kept alive through artificial means and is overdue for an end. The new bear market will unfortunately make the broader stock market appear more overvalued than it already is, and be a serious shock to the financial system.

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.

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