Pricking the Bond Bubble

By far, the best trade of the fourth quarter of 2008 was owning government bonds. It didn't matter what the duration, rates dropped dramatically and quickly. The main reason was doubtless fear. Fear of economic collapse, fear of worldwide financial system collapse and fear of pretty much the end of the world. The most obvious indication of the fear was the yield in the three month T-bill dropping to 0%. Imagine -- paying the government to hold your money because there is no other option that gives you the security and safety you are looking for.

The other reason for the drop in rates and rally in prices is liquidity. We hear of the $750 billion TARP, the possible $10 trillion on the balance sheet of the Federal Reserve and the capital infusions into financial institutions. This is a massive effort to reliquify the system, and just as in previous periods of easing, the liquidity has to find its way somewhere, and it has found its way to government bonds.

This is the next bubble being created. We had the technology bubble, the housing bubble, the commodity bubble and now the bond bubble. Interesting how we hit all four major asset classes in under 10 years. Bubble durations are hard to determine, and the extreme to which they will move is also hard to determine. Knowing it's a bubble doesn't always mean you can profit from such an occurrence or avoid the associated risk.

With all that said, the last few days of price action have been volatile and are showing signs of at least some of the air coming out of that bubble. The short-term trends that have been intact since the rally began are breaking. The two-day drops have also been extreme, with prices falling more over the last two days than any two days of rally. That is a warning sign and suggests that the bulk of the money is in bonds now, and there are few buyers to step up to support prices at this point. This is happening over all durations, from two-year notes to 30-year bonds.

This remains an aggressive idea, but shorting the bonds is actually a trade with low risk and potentially high reward. We can do this through one of three ETFs -- the iShares Lehman 1-3 Year Treasury Bond Fund (SHY - commentary - Cramer's Take), iShares Lehman 7-10 Year Bond Fund (IEF - commentary - Cramer's Take) or the iShares Lehman 20+ Year Bond Fund (TLT - commentary - Cramer's Take) We will use the SHY for our trading idea.

The two-bar reversal near the recent highs with an expanded range suggests exhaustion near term, as buyers could not maintain these levels. The pullback has violated the uptrend intact since September and has also violated the previous reactionary high.

All of this suggests sellers are gaining the upper hand and we should look for prices to move lower. Short at current levels and stop out on a move above $85.50.

---

Know what you own: A number of bond-related ETFs might be of interest to readers of this column, including the SPDR Lehman Short-Term Municipal Bond ETF (SHM - commentary - Cramer's Take), the SPDR Lehman Municipal Bond (TFI - commentary - Cramer's Take) ETF, and the iShares Lehman 10-20 Year Treasury Bond (TLH - commentary - Cramer's Take) ETF.

---

At the time of publication, John Hughes and Scott Maragioglio had no positions in the stocks mentioned. Hughes and Maragioglio co-founded Epiphany Equity Research, which has developed and utilizes proprietary tools to identify and track liquidity changes in the market indices and sectors. Hughes advises numerous asset managers, hedge funds and institutions managing in excess of $30 billion. Maragioglio is a member of the market technicians association (MTA) as well as The American Association of Professional Technical Analysts (AAPTA) and holds a Chartered Market Technician (CMT) designation. Maragioglio has also served on the board of directors of the AAPTA.