Bonds Stretched Like a Rubber Band

Today's Idea

Bonds have found strength in the weakness of troubled EU debt and economic doubts. The Bond market has several potential problems working against it. There is the high likelihood that the debt ceiling will be raised to stave off a default, which will likely create high supply. Also, the success of treasuries has been its own worst enemy, due to yields falling to levels that many investors feel is inadequate. Technically, the chart does not show any signs of a letup, but the oscillators are beginning to hint toward a reversal in the future. Some traders may wish to consider entering into a bear put spread with a bit of time in the event that the market does turn. One such strategy would involve buying the August Bond 123 puts and selling the August 120 puts for a debit if 0-32, or $500. The trade risks the initial cost and has a maximum profit of $2,500 if the underlying September contract closes below 120 at expiration.

Fundamentals

Bond futures continue to climb, as investors look for high quality assets to add to their portfolios. The EU looks poised to bail-out Greece for a second time, but the bailout is like using a band-aid to cover on a deep gash. There are serious flaws in the Greek financial system, and the government has not, or possibly cannot, put in place enough reforms and spending cuts to meet future obligations. The EU is truly in a "damned if you do, damned if you don't" situation with Greece. Leaving sovereign debt holders holding the bag could cause yields to skyrocket across the Eurozone, but on the other hand, simply throwing more money into a sinking ship does little to enforce investor confidence or encourage responsible government spending in member states. The US is far from being the poster child for sound finance. Economic indicators keep weakening, with the housing market edging closer to a double-dip and the economy failing to create jobs. There has also been the debt ceiling debate and the call for more spending reforms. This has created demand for the relative safety of the Bond market. One major problem with treasuries rallying and yields falling is that yields on long-dated debt have fallen below the expected future rate of inflation. The Bond market has been stretched like a rubberband and something has to give - either treasury prices have to pull back or economic growth around the globe has to fall enough to cool inflation for an extended period of time. Some traders who bought the tail end of the rally could soon be regretting the decision to do so. As strange as it sounds, the strength of the Bond market could spark further advances in equities. With yields being this low, investors may be willing to stomach the economic risk and purchase stocks with either growth potential or high dividend yields.

Technical Notes

Turning to the chart, we have seen the Bond contract advancing to the highest levels this year. The next area of stout resistance can be found near the mid-128's and a close above the November relative high at 128-23 could result in a test of the 130 mark. Near-term support comes in near the 123-16 mark, and more stout support comes in near 122. It is interesting to note that RSI remains near overbought territory, as it has for over a month. RSI, though, is slightly fading despite the rally in prices, suggesting a turning point could be on the horizon. Momentum has also failed to keep up with prices.

Rob Kurzatkowski, Senior Commodity Analyst