From the Desk of Ian Culley @Ianculley
Heading into Q3, we wanted to play a mean-reversion bounce in US treasury bonds. A long list of reasons supported this position:
- US Treasuries experienced their worst H1 in history (or close to it).
- Bonds were finding support at their previous-cycle lows from 2018.
- Commodities and inflation expectations peaked earlier in the spring.
- Assets that benefit from rising rates (financials) were making fresh lows.
- Global yields were pulling back.
And, quite frankly, our risk was well-defined. We can’t ask for much more. For us, the greater risk was not taking a swing at this trade in the event bonds ripped higher…
Two months later, bonds across the curve are taking out their 2018 lows. The market has proven our mean-reversion thesis wrong. But we can live that because we manage risk responsibly.
It’s the most important part of playing this game.
Easily, the second-most important is to remain flexible.
As investors and traders, we have to be able to change our opinion on any given market, especially when the data no longer supports our thesis!
We’re going to check that box today as our outlook pivots lower for bonds heading into Q4. Basically, if US treasuries are below their 2018 lows, you've got to be short!
These charts all look very similar, as it all comes down to the prior-cycle trough marked by the 2018 lows.
It doesn’t matter what duration bond we’re outlining. Those former lows are our line in the sand.
First up is the 30-year Treasury bond futures:
After an impressive bounce off the June lows, T-bond futures have slipped back below their 2018 lows at 136'16. As long as it’s below that level, we want to be short with a target of 127'23.
Next, we have the long-duration bond ETF $TLT:
TLT also rebounded higher after undercutting its prior-cycle lows. These were the bounces we wanted to ride higher back in July. But, now, it's back below those critical former lows near 112.
It’s simple: We can’t be long below that level.
Instead, we like TLT short if and only if it's below 112 with a downside objective of 101.50.
Again, these charts are all very similar, so I zoomed in on the 10-year T-note for a different perspective:
Like many US Treasuries, the 10-year T-note bounced higher after taking out its prior cycle lows. In the process that followed, it formed a multi-month inverted head-and-shoulders pattern.
That reversal pattern failed yesterday, as bears pushed price below the low of the right shoulder. We want to get short below the pivot low of 117'14, targeting 111’16.
Here’s the corresponding ETF $IEF:
Interestingly, IEF has not undercut its former 2018 lows of 99.50. It’s actually the only chart in today’s post that hasn’t.
If and when it does, we want to sell weakness on a breakdown with a fresh target near the 2011 lows around 91.
As we move down toward the shorter end of the curve, the further the bonds get from their 2018 lows. The five-year T-note is a great example:
It broke back below our risk level of 112 last week, leading the way lower. Our outlook is bearish as long as it's below that key level, targeting near 103.
In the event the five-year breaks back above those crucial former lows, we can’t be short.
Also, a failed breakdown in the 5-year would call into question the downside resolutions further out on the curve. So we want to keep an eye on the five-year as it often leads in either direction.
Last but not least, we have the three- to seven-year US Treasuries ETF $IEI:
IEI is breaking down below its prior cycle highs at 118.15. We want to get short below that critical level, targeting 113.
It’s simple: If bonds are below their prior-cycle highs, we’re short. The fact that the vast majority of these markets trade below their 2018 highs tells us one thing.
Interest rates are still on the rise.
This is critical information regarding the broader intermarket landscape. If risk assets experience another bout of selling pressure while rates continue to rise, the only place to hide will be the dollar.
Whether another leg lower for stocks will come to fruition is unseen. But the currency market has been rewarding dollar bulls for months now.
And the bond market is instructing us to sell Treasuries.
It’s something to keep in mind as we head into what is seasonally the worst month of the year, September.
Stay Tuned!
Countdown to FOMC
Following Powell's Jackson Hole speech, the market is pricing in a 75-basis-point hike later this month.
Here are the target rate probabilities based on fed funds futures:
Click the table to enlarge the view.
This data is from the CME FedWatch Tool as of September 1, 2022.
Thanks for reading. And please let us know what you think.
As always, be sure to download this week’s Bond Report!
