Why you should be worried about the bond market
By
Dominic Frisby May 06, 2009
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A collapsing bond market means higher interest rates
A lot of people have been asking me: 'What's next?'
Sentiment everywhere is improving. In fact, I was astonished to hear such bullish talk from the likes of Anthony Bolton and Crispin Odey this last week. Their records and experience dwarf mine, but I see an intermediate top coming in the stock markets more or less now. In fact, I think we may have made it on Monday.
What's more, I am observing a worrying trend in the bond market, both for US Long Bond (the 30-year US Treasury) and for UK gilts. Even now, after months of attention due to the Bank of England's quantitative easing plans, I suspect that few people – or politicians for that matter - are really that interested in government bonds. But, believe me, the last thing we need right now is a collapse in the bond market.
Unfortunately, it could be just around the corner...
Is this stock market rally over?
Looking first at the stock market, it's worth reminding ourselves that bear market rallies of 20% or more are perfectly normal. This first chart from Tom Denham of www.Elliotwave.com shows how there were seven rallies of 19% or more in the Great Stock Market Crash of 1929–32. Note how fast and violent they all were.
In other words, this phenomenal rally we have seen in stock markets since March 8th is, both in its size and duration, a perfectly normal occurrence in a rotten bear market.
This next chart from Flint Stephens at MarketOwl.com is also worth considering. It shows the S&P 500 from March 2000 until October 2002. Even though the index lost 48%, there were four rallies of 18% or more.
Why do I think this rally should peter out now? Looking at the S&P 500, rising some 36% from early March to Monday's high at 910, this has been one of the greatest two-month rallies ever seen. Rallies of this magnitude should at least retrace. Volume levels are down, which would suggest a loss of momentum. What's more, there is a great deal of resistance in the 900 to 950 area. It took several attempts to rally through this level in 2002 and it also proved the stumbling block in December last year, and January this year.
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I have drawn some lines on the chart of the S&P 500 since the highs of October 2007. There is a clear channel in place and we are hitting the top of it. It's a long way to the bottom. I'd love to know what Bolton and Odey are seeing that I am not, but in terms of risk-reward, stock markets must be a sell here. It's May, for goodness sake. How many times do we need to learn the lesson, 'Sell in May and go away'?
Banks' problems are far from over
We might need some bad news to upset sentiment. And it may already be coming. After hours last night, Reuters reported that the Bank of America has been deemed by its government stress test to need as much as $34bn of extra capital. Meanwhile, General Motors announced in a filing with the SEC that it is issuing 60 billion new shares, a move which, if it meets with US Treasury approval, would dilute common shareholders into oblivion. Those titbits might kick things off.
But perhaps more worrying are concerns over the bond market. The Federal Reserve has been buying into the US government bond market with the aim of lowering interest rates across the economy. But despite its plan – announced in March - to buy $300bn worth of T-bonds to keep rates down, long bond yields have actually gone up (yields rise as prices fall). Could this trend of rising prices, which has been in place since the early 1980s, finally be over? Here is a chart of long bond prices since 1979.
Here it is in close-up, since 2006. After that colossal spike-up in late 2008, which some are arguing was the blow-off top to mark the end of the bull market, we appear to be moving lower. It is now sitting on its 52-week moving average. There is a lot of support from 122 to 112.
The massive provision of credit or 'liquidity' from the US government has helped this recent stock rally. But if government's own long-term borrowing costs go up, so – in the long run - will rates across the rest of the economy. This could add to the pressures on the US housing market, just as it seemed to be stabilising. Add to this mix the problems that may still lie ahead in credit cards, corporate loans and the commercial property market, and you can see that the problems of the banks, and the wider economy, are far from over.
Are higher interest rates just around the corner?
A collapsing bond market means higher interest rates. At the moment those in debt are not suffering too badly – those with tracker rate mortgages, for example, are sitting pretty at the moment. But higher rates will decimate anyone with any debt, be they individuals, companies or governments. They are the last thing the economy needs just now.
Now the Fed is still able to borrow in the shorter term at low rates, so this may not have an immediate impact. But the drop in bond prices in the last five months is an early warning sign that markets will only prop up even the world's largest economies for so long.
Those who want to short the long bond might consider the US-listed exchange-traded fund, TBT. But with the bond market already having made a big move down, I do not see now as a good entry point. Keep an eye on this market though and await a pull back before entering.
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