Bond Market Buy Signals

After experiencing a sharp decline in the last ~2 months, bond markets is now consolidating. In fact, today it managed to rally above a critical level. If bonds can hold near this level for the next few days, intermediate trend would turn up.

This decline has resulted in multiple bond indicators turning bullish i.e. sentiment turning so pessimistic that it is now bullish. Three widely followed sentiment indicator readings are given below:

1- Hulbert Sentiment Index:
The blue line below represents bond yields. Bond yields move in the opposite direction to the bond prices. Red line indicates the sentiment towards bonds. At this point, it appears that the sentiment is as negative as we have seen in ~2 years. Therefore, there is a good wall of worry to support a bond rally.

2- Bund Sentiment
Bunds are German bonds. Bunds were among the bonds that went into negative yield territory. While they were negative, everyone was bullish on the future of Bunds. However, very few realized that it was more close to the end of the Bunds rise. On the contrary, right now investors are very bearish on Bunds. This suggests that this a good time to increase exposure to bonds

3- Bond Sentiment NDR indicator
According to NDR services, bond sentiment is now extremely pessimistic, which supports the argument that the Bond decline is over-extended and we should anticipate a rise in Bond prices:

Bond Market Trend
While we are seeing some very pessimistic sentiment readings, these are coming at a time when the Bond market remains in a bull market according to our proprietary Market Classification Model. Therefore, the prudent trade right now would be to add or maintain longs in the bond market.

Keep in mind that bond market has been rallying for over 30 years, and yields have been declining for the same period. This trend will eventually come to an end. The question is whether it has already ended or will end with one for decline.

In either case, bond yields will not go up right away. They will go up if the economy continues to improve and Federal Reserves raises interest rates couple of times. Fed's changes to short-term interest rates does not directly impact the longer-term interest rates because those rates are driven by market expectation.

In the next blog post, we will discuss the bond market structure and both Bull and Bear scenarios. Poor bond market is in no one's favor and the central banks will try their utmost to ensure interest rate rise remains in control. From an investment perspective, we might see 1 or 2 more opportunities to fund big capital purchases at a lower interest rate.

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Bonds Market Analysis and Impact

After a dynamic and super-charged start of 2016, the long-term bond prices, as measured by TLT, are at the same level where they started the year - 120.6 vs 120.7 (shown below).

 
Above chart shows the amazing ascent and first six months and the sharp decline over past 4 months. Today's news is full of negative articles about the bond market rout, and potential consequences.

Bond market is the life blood of modern economies. There is hardly any developed country in the world that is debt free. Countries issue debt/bonds to implement development projects and repay any interest/payments that are due on existing obligations.

United States is a unique case where the government cannot just keep issuing bonds to raise money without any checks and balances. These checks and balances help keep the government debt in control, which supports the dollar and increases confidence among the lenders that they will get their money back.

This check/balance process is known as the debt-ceiling. Without confidence in the system, creditors might start hesitating in purchasing government treasuries, which could lead to higher bond yields, making it more difficult for US to finance future needs.

Orderly, rise and fall of treasury yield is very normal because it is governed by economic realities and Fed's actions. But sudden sharp rise, can be catastrophic for the overall economy. That being said, we are in a long-term downtrend in the bond yields, which will reverse one day in the near future.

Long-term view
In early 1980s, long-term treasuries were yielding 14%. They went as low as 2% in July 2016 - amazing time to refinance or make a big purchase at next to no interest rate.

However, this kind of decline will not last for ever. Typically, there is a ~30 year bond market cycle and right now we are near the bottom of the yield cycle. Following chart shows the yield decline structure.

Now the question is whether this trend has ended or does it have one last decline left in it? 

From a fundamental perspective, it is difficult to rationalize how the inflation can pick-up with oil, gold and other commodities being hit with higher dollar. If dollar rallies, it will pressure inflation and as a result, yields would come down.

Short-term View
From a short-term perspective, bond market has become extremely oversold. The sentiment is conducive to a sharp rally, as investors start to rationalize higher yields through new post-election economic realities. DSI sentiment is also extremely subdued.

Note - Election or no-election, economic realities don't change randomly. Rather, their interpretation changes but in the end everything cancels out in the direction of the primary trend

Following chart shows the near-term structure of the bond market. There are two ways to decipher this structure, but both ways suggest that this is a corrective structure. Below chart shows both the wave counts.

We will continue to monitor the bond market as we approach next month's Fed FOMC meeting. Fed might not raise the rates after an election surprise, which could give a boost to bond market.

Last Word
A collapse of the bond market will be a very bad scenario for investors and the economy. Abrupt rise in interest rates can destroy US abilities to pay existing obligations and could lead to a significant market impact. This impact might start from the US but could quickly spread through out the world. And once such a spiral starts, it is almost impossible to halt it in the middle.

If you are an investor with a substantial portfolio in bonds, you need to carefully watch for trend change in the bond market. Our proprietary Market Classification Model remains in a bull market for Bonds.

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Another Decline But Why Such Disorder??

So today markets declined yet again, it can be attributed to president's panic button or to relentless bickering in D.C. In any case, market was down sharply in the morning. Although it recouped some of the losses by the end of the day, it still ended sharply in red.

There are two interesting aspects of this decline:

1- Except for DJIA, there is no order in the decline.  Market is going up and down, with some indices near the highs while others near the bottom of the range. This kind of behavior is not consistent with a start of a strong down trend.

DJIA is showing a sharp decline since September 18 peak.

Russell 2000 is showing sideways market action since September 18.

SP500 is showing a sideways to down action since Sept 18 peak. 

Cumulatively there is nothing impulsive about these three markets and their declines, which suggests that we should consider this decline as a correction within a primary up-trend.

2- Over the last 2-3 days, we have seen panic coming back into the market. Sentiment surveys have started to show less optimism. Moreover, we have also received 2 buy signals from VIX and NYMO indicators. Therefore, this is suggesting that market correction is approaching an end.

Based on this analysis in conjunction with the IPM turn window, it is possible that market might be setting up for a stronger rally than what we had anticipated 1 week ago. If DJIA breaks below August lows then rally scenario will take a back seat.