Bond Breakdown Could Pay Off

During what feels like maximum panic from the equity markets, it may seem crazy to be talking about an improvement in sentiment, but the bond market is sending just such a signal. We have written recently about the "fear trade" and the flight to quality into government Treasuries over the past year.

As the financial crisis has unfolded and confidence in the systemic health of the financial system has waned, capital has fled to government Treasuries. Treasuries have been seen as the only "safe haven" in the capital markets, and have been pushed higher and yields in the shortest-term maturities have moved below 1%, marking extreme fear and uncertainty.

Recently, we have seen a break in this "fear trade" and a sign that fear is receding and that inflation is moving to the forefront as a concern. Traders can take advantage of this change and look to short the longer-maturity Treasuries as panic ebbs and the realization that government intervention in the capital markets comes at the cost of inflation settles in.

The price action in the equity and bond markets have converged in recent days. As the stock market collapses and equity traders slip into pure survival mode, the longer-maturity bonds have broken down. Shorter-term maturities have held on, but they have failed to move out to significant new highs. This isn't surprising, since yields can't get much closer to 0%.

This collapse of longer maturities is unusual to see, considering the environment, and in our view, this is a confirmed break in the "fear trade." Money is no longer flooding into Treasuries as a safe place to hide.

The second issue is inflation. In our opinion, the fear of deflation is not valid when we consider the unprecedented amount of liquidity the government is pouring into this market. The Fed and Treasury Department have pulled out all the stops and will very likely overshoot on adding liquidity.

When we combine the financial crisis with the war in Iraq, government spending is extremely inflationary. The combination of a bottom being reached in the stock market and inflation concerns should continue to drive longer-term government treasuries lower for quite some time.

10-Year Treasury Bond

Click here for larger image.

We have talked about shorting the 10-year Treasury in the past, and we still believe this is a trader's best bet on the short side. The 10-year bond has broken down from the short-term uptrend channel established in June. The 10-year tested the prior March highs in September and failed. The break of the trend channel has led to downside acceleration in recent days. A move below the June lows would confirm a double top in the 10-year and signal that the bears are taking control of the bond.

Ultra-short Lehman 7-10-year bond ETF

Click here for larger image.

Traders can either short the 10-year Treasury futures or you can buy the Ultra-short Lehman 7-10-year bond ETF (PST - commentary - Cramer's Take). PST is challenging the overhead resistance line at $68, and the ETF has broken the short-term downtrend channel. We would buy the fund on any break over $68 and place a stop-loss below the recent lows at $62. Traders should look at this as a long-term trade and let the bond roll over and develop into a bear market.

---

At the time of publication, John Hughes and Scott Maragioglio were long the Ultra-short Lehman 7-10-year bond ETF. 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.