Saturday, June 18, 2011

The Bond Story - Case for QE3

Over the last few days, I have heard a lot about a possible stock market crash, 10%+ correction, end of QE2, global socioeconomic uncertainty, impending Greek bankruptcy and much much more. As a result, I decided to look at long term Treasury Bonds charts to decipher the market behavior.

Following chart shows the 30 year bond yields since 1980 top. 
Figure 1

Bond yields have been falling since 1980s. Consequently bond prices have been in a long term bull market. However, recently we started hearing a lot about the end of the bond bull, and the beginning of a new multi-year bond bear market with higher yields.

I would agree that one year ago people were very bullish on bonds and rightly so because bonds had been rising for the past 30 years. However, to my amazement people turned bearish very fast. Many experts like Bill Gross of PIMCO not only exited his US treasury bond positions, he even went short. 

Figure 2
In this regard, I came to a totally different conclusion after carefully analyzing the historical bond market data from daily, weekly and monthly perspectives. It seems like that over the past 3 years, the bond market has been carving out a triangle pattern (not complete), as seen on the left. 

Triangles are continuation patterns, and lead to sharp move in the prior direction. In this case, the move out of the triangle pattern would mean that we will soon experience a sharp decline in bond yields and a sharp rise in bond prices.  

Implications of such a move are very severe because bond yields decline would mean the following: 
We are about to see a sharp rise in Bond prices, which happens in situations of extreme fear. Therefore, we might be heading towards a depression, sharp stock market decline and commodity bear market.

However, in order for the triangle pattern to complete the bond yields need to rise once more in an 'e' wave (shown in fig 2). This rise in yields would result in declining bond prices. The following chart paints a very interesting picture this regard.
Figure 3
This chart highlights the impact of QE announcements on the bond prices i.e. Bonds decline after the announcement of QE e.g. QE1 in Dec 2008 and QE2 in August 2010 (If you invert this chart, you will get the yields). Now, lets put together various pieces of the this convoluted puzzle:
1- Next week is the FOMC meeting 
2- Economy is lagging
4- Unemployment is high
5- Bond prices have been rising for the past several weeks
6- Bonds need final 'e' wave to complete the triangle pattern

Under these circumstances, it would be highly coincidental if the Fed announces QE3 or something similar. This announcement could result in lower bond prices completing the 'e' wave, and allowing the stock market to rise further into October 2011. After that bond prices might be ready to embark on their final rally leg, changing the face of economy as we know it. 

Note: In order for this scenario to play out, bond prices should not decline below the first low made after QE1 announcement. 

This is a hypothetical but an interesting possibility that I wanted to share with my readers. But it should not be treated as the best indicator of the future stock market movement. I will be presenting the latest readings of the Market Matrix & Market Barometer over the next few days, delineating the market behavior from various perspectives.

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