Technicals Show Bond Market Could Be Ready for a Turnaround

Economic data haven't been friendly this year to the bond market. But some technicians believe the yearlong selloff could be over.
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On a fundamental basis, the bond market hasn't been in great shape: Consumer demand still hasn't slowed, global growth is heating up, and the

Fed

threatens to raise interest rates again in a couple of weeks.

In times past, a confluence of those three bond horrors would have made

Norman Bates

seem downright cuddly.

But the way some technical analysts see it, there's no need to worry. Having lived through a yearlong bear market, some technicians believe that bonds are poised for a turnaround in the next few months.

Looking at the fundamentals, how is this possible? Several loyal technicians believe that a fundamental trigger will soon present itself, whether it's a decline in inflation or a slowdown in economic growth.

"I can't tell you what fundamental will make that so, but it's always a surprise and always a lethal shocker," says Jim Grauer, president of

Stomaster.com

. "No two cycles are the same fundamentally."

Technical Fouls

Why do people look at technical indicators at all? Sometimes, charts can demonstrate where people perceive value in a bond, even if the current economic data are bearish. Technicians predict the direction of bond prices based on chart movements from the previous weeks, months or years. Some people follow technicals ruthlessly, ignoring fundamental news.

Tony Crescenzi, chief bond market strategist at

Miller Tabak

, isn't that radical, but he believes it is "important to intertwine technicals with fundamentals. At any one time, one could be missing a signal from the other. Fundamentals can drive a market lower, but maybe technicals show the move is excessive."

Some are betting that this year's selloff has already reached excessive levels. In 1994, the bond futures contract, traded on the

Chicago Board of Trade

, experienced the worst selloff in its 20-year history, dropping 26 points from 122 to 96 over 12 months. Since hitting 135 in August 1998, the contract has lost 24 points to 111 15/32 at Thursday's close.

Is the Selling Over?
Closing price of futures contracts, Oct. 1998 - present

Source: Reuters

A quick look at the above chart has Mike McGlone, vice president at

Aubrey G. Lanston

, convinced that the bear market is 95% finished. "We're in the very last, latter stages of higher yield correction, at least for now," says McGlone, who turned bullish a few weeks ago. "To me, the market is an oversold condition. You cannot set up a short position at these yield levels -- you're asking for trouble." By the same token, it's too early to go long, the strategist says. "You don't want to grasp at falling knives."

Some technical analysis takes a less sweeping view. Often, technicians look for a trend line by essentially playing connect-the-dots with several points on a chart that they've identified as support or resistance levels. If the market rallies through an identified line of resistance, that's bullish. Conversely, falling through a support line is bearish.

Walter Burke, technician at

MCM Moneywatch

, has drawn a line based on the lowest intraday prices for the bond contract since mid-June. It extends to approximately the 112 1/2 level. The futures broke 112 for the first time in 10 days today, a bullish signal. Were they to reach -- and maintain -- this level, that'd be a strong signal that a rally will commence in the next few months, Burke says.

Cruel, Cruel Summer
Futures contract from June 1999 - present

Source: Reuters and MCM Moneywatch

"You'd start to build a case that the bear market could be ending," Burke said on Monday. "Until then, the downtrend remains intact."

There's the Rub

The "on the one hand, on the other hand" nature of Burke and McGlone's statements reveals the problem with technicals. At times, they're so subjective that they are meaningless. Things may be great, unless they're terrible. Not surprisingly, some analysis says the bond market could be headed for more trouble.

For the most part, since 1994 bond yields have done nothing but go down. The yield on the 30-year bond dropped from 8.16% in November 1994 to 4.7% last October. Since then, the yield has risen as far as 6.4% earlier this week. According to

Salomon Smith Barney

, the 6.45%-to-6.5% level is a dangerous spot for bonds, because it means that 50% of the rally beginning in 1994 has been undone.

The Yield Retraces Its Steps
30-year bond since Jan. 1993

Source: Reuters

Were it to bust past that level, it could present some potentially bad news for the bond market. "Theoretically, it invalidates the move down in yields," says Crescenzi. "It would make it seem as if the whole move up

in prices was not valid in the sense that there weren't good reasons for it."

Which is to suggest that the fundamentals that drove the rally -- low inflation and decreased supply of Treasuries -- pushed the market too far. Depending on which way things break, those factors could be the prime contributors to another rally.

Right now, the bearish case might be the easier one to make from a fundamental standpoint. But Grauer says he felt the same way in 1994, after the Fed had raised the funds rate half a dozen times and bond yields were at their highest level in 2 1/2 years. Wednesday, technicals started the rally -- and it hasn't stopped yet.