Big Extremes in Bonds and Yen
By Frank Barbera CMT. December 9, 2008
With the evidence of the global recession deepening steadily over the last three months, we have seen a near continuous liquidation work its way through the hedge fund community, where highly leveraged trades borrowed in Yen have been forced to liquidate. The result has been a tremendous flight to quality and a flight to liquidity with US long term bonds a prime beneficiary. Thus, as the Dollar, Yen and Treasury Bond have gained strength, virtually all other markets have collapsed with asset values across a very wide spectrum under very steady selling pressure throughout this time. Perhaps no asset has been under more pressure than Oil, where prices briefly approached $40 earlier this week. Yet even as the air waves of cable TV fill with fervent deflationary forecasts for even lower Oil prices and even lower bond yields, the evidence continues to mount that the current extremes look historically overdone. I believe Treasury Bonds are the last great bubble yet to pop. As the New Year approaches and a great deal of the forced hedge fund liquidation comes to its end, odds are high the Treasury Bond yields will begin to reverse and chart an upward course during the first quarter of 2009. In my view, Bond yields are near what promises to be an historic secular low.
Above: Secular View US 10 Year Treasury Bond
In my analysis of Bond yields, I approach the market from several different angles including the more controversial Elliott Wave Theory. In looking at long term bonds thru the lens of Elliott Wave, I believe the entire decline from the 1981 peak near 15% has been a set of ‘three’s” which are “A-B-C” movements. From September 1981 to September 1993 bond yields fell from 14.14% to 5.37% creating a low for Primary Wave (A) in September 1993. This was then followed by a counter-trend A-B-C correction which peaked Primary Wave (B) at 6.67% in January 2000. From there, the second declining, A-B-C sequence began with the most recent decline from the June 2006 peak at 5.25% to present representing the final ‘C-Wave’ decline and theoretically bringing the secular low into view. With yields in the 2.50% range, the second A-B-C decline is now equal in percentage decline (see bold lines on chart above) to the scope of the first A-B-C decline seen between 1981 and 1993. That means the 2.50% zone on the 10 Year Bond is likely to host a very important secular low.
In the daily chart above I show my interpretation of what a final low in Bond yields might look like projecting forward over the next few months. Obviously, there is no guarantee that my scenario will materialize, but I believe this type of outcome has a good chance. For most of 2008, Treasury Bond yields traced out a five triangle (labeled A-B-C-D-E) with the E wave triangle peak seen on October 15th at 4.11%. Since then, the market has traced out a second five wave decline which is Intermediate Wave (C) of the larger, long term Primary Wave C. At present, the 9 day RSI is still deeply oversold, with the 10 Year Bond ripe for a few days of selling, perhaps enough selling to raise yields toward 2.95% over the next few days. From there, I would expect yields to once again trend lower in erratic fashion over the next few weeks. Given the massive amounts of downside momentum behind the decline in yields, it will take several more weeks likely into mid to late January before bond yields have constructed and possibly completed an important medium term low.
Yet, I believe this kind of outcome is generally indicative of the path ahead. Too much money is being printed up with quantitative easing now in full swing, the Central Banks are fighting deflation and politicians being “politicians” they are likely to win once again. In this world of great stress and turmoil, as people suffer steadily increasing hardships, it will be all too easy for the politicos of the day to promise an ever increasing number of handouts, and hence money supply will bulge in the months ahead.
Over the next few weeks, I will be watching closely to see more signs of positive divergence on the 9 day and 14 day RSI, neither of which has these divergences in place at this time. Ultimately, there are several important flash points to be watching on the upside, “if” and “when” Bond yields begin to reverse. Of these important resistance levels, any move back above 3.30% in the first half of 2009 would be a strong indication that the secular low in Bond Yields is completed. I highlight the 3.30% range with a small, thin rectangular box in the prior chart. Moving back above that line would signal a longer-term bullish trend reversal for yields.
Above: 10 Year Bond Yield with Monthly 20% Envelopes
The next chart takes an even longer view of Bond yields using a monthly 20% trading envelope and a long term moving average. Notice that during the last great bear market in bonds, seen between 1945 and 1981, bond yields generally remained above the middle band. This has since been followed by the last 25 years, where bond yields for the most part have remained below the middle band. At the 1980 major peak, yields experienced an upside blow off moving up and outside the upper band prior to trend reversal. This was an indication of a long term trend in its climactic phase. The opposite is now unfolding, with yields collapsing down and outside the lower band.
Above: 10 Year Bond with long term %B Gauge
In the next chart, we construct the Bollinger %B Gauge for Bonds which simply computes where yields are relative to width of the bands. With zero at the neutral value, readings of +50 and –50 have been important extremes. Notice that with current readings near –100, we presently reside at the most extreme downside value ever seen. Does this guarantee that yields must go higher? Of course not. In fact, we would be surprised to see a real reversal in bond yields before mid to late January 2009 at the earliest. Nevertheless, we would point out that prior extreme values seen in April 1986 (-84.38), September 1993 (-74.67), September 1998 (–76.66) and September 2002 (–91.77) all corresponded closely to major lows in yields and very sharp downside reversals for Bond prices. Put another way, for those just entering the bond market, current values should be good reason to think again as the Risk/Reward equation for Bonds has likely never been more negative.
Above: 10 year Bond with long term moving average and Shadow Line
Continuing our review of the longer term trend in yields, we strip away the trading bands on the next chart and instead plot both the long term moving average and along with a moving average Shadow Line. This is a moving average of the moving average which is designed to only cross on rare occasions. While no trend following system is ever close to perfect, in the case of the Treasuries is easy to see the enormous downside cross over which took place in December 1985. Such cross-over’s will always occur well AFTER an important turn, but can be helpful in placing the exclamation point on the prior secular trend. At present, the Moving Average + Shadow Line combination stands at 4.32% on the 10 Year Treasury and any move above that level during the course of 2009 would affirm that a secular trend reversal has most likely been seen. Such a definitive cross-over would likely not be seen until the second half of 2009, and possibly not before Q4 2009 as that type of move up in yields will take some time to achieve.
In addition to the historic move to the downside in Treasury Bond yields, (flight to liquidity), we have also seen a dramatic spike to the downside in the Euro-Yen Cross. This cross-rate is the very heart of the downside selling pressure which has plagued so many markets over the last few weeks and the poster-child for massive hedge fund redemptions. The chart below shows the close relationship between the Euro-Yen Cross and the price of Oil as bout after bout of selling pressure has battered Oil prices below $50 in recent weeks.
Above: Euro-Yen Cross Rate and Crude Oil (bold)
Yet, with a closer view, we note that the price action on the Euro-Yen Cross appears to be completing what could be an important “W” type bottom. As can be seen on the chart below, the extreme downside momentum for the move was seen back on September 11th , a few days before the stock market began to crash. Since then, RSI made a higher, less negative low on October 27th with RSI closing at a reading of +18.85. The period of real improvement has taken place over the last few weeks right up thru the present time period where we find the Cross rate right back down to former lows but with RSI now nowhere close to the prior lows. This argues that a lot of the heavy selling stemming from hedge fund carry trade unwinding could now be coming to an end with a downside reversal in the Yen dead ahead.
Above: Short Term view, Euro-Yen Cross and 14 day RSI
Above: Long term view Euro-Yen Cross Rate and long term annual RSI.
The final chart for today’s report shows a very long term perspective on the Euro-Yen cross, this time with an annual 255 trading day RSI. Like the situation shown earlier in the long term US T-Bond, the Euro-Yen Cross is at an absolute historic oversold value and the kind of reading which could well signify another secular low. In August of 1993, and in August of 1997, the Cross Rate found very important bottoms at these same levels implying another major low could soon complete. For the equity markets, a turn to the upside in bond yields, and to the upside in the Euro-yen Cross would suggest a new cycle of reflation taking shape, and possibly the birth of a new bull market in stocks as 2009 unfolds. For now, we are providing only the broad backdrop as we see it with a full knowledge that the next few weeks – the near term -- will remain quite choppy.
That’s all for now,
© 2008 Frank Barbera