Technical Outlook: Bond Trend Emerges

The continued craziness in the market is marked by the extremely wide percentage swings its indices make over a matter of just minutes. Such wide swings have in the past been typical only over the course of an entire year. This type of volatility can certainly exhaust individual investors, and the combination of fear and fatigue often leads to a bottoming process.

Readers know that over the past couple weeks I've been becoming slightly more optimistic regarding the potential for more upside in the market. In my column last week I noted that my indicators didn't quite give off a short-term buy signal, but they were very close.

I reported in my RealMoney.com column this morning that my indicators have turned decisively positive, giving off a short-term buy signal. I recommended taking a small position in the exchange-traded-fund market proxies when they break above Thursday's highs. The key is to kept positions small and have close, protective sell-stops a few percent below Tuesday's lows.

There is also another possible longer-term trend that I see developing in the market that has the potential to be tremendously profitable if played right. With the government's new bailout plan and the billions of dollars of money being printed and pumped into the economy, it's useful to note that the repercussions of such trends throughout history have always resulted in tremendous inflationary pressures.

Of course in the short term, until the money works its way through the economy, the likelihood of deep recession and even deflationary pressures can exist. However, whenever money is being flooded into the system, the end result has been rampant inflation and higher interest rates.

Currently, 10-year interest rates are trailing near historic lows. The other catalyst that could prompt higher rates comes from the fact that the recent bailouts have reduced the credit worthiness of the U.S. government's financial instruments. As a result of this, worldwide buyers of U.S. Treasuries want higher yields for taking what is now perceived as a higher-risk situation.

The major problem here is that if overseas investors continue to perceive that the U.S. government is taking on too much debt, these investors will insist on higher rates before they buy our Treasuries. That pressure could trigger a sharp breakout of the 10-year yield to the upside.

OK, let's take a look at the charts and see how we can profit from this trend if it indeed develops.

You can see from the long-term, nine-day chart below of the 10-year Treasury Yield index that it has been in a steady downtrend for many years. In 2003, at the bear market bottom, the rates also bottomed and then reversed and trended higher over the next four years. However, that rally never took rates above the long-term downtrend line. The chart shows a double bottom appears to have been forming this year, which often leads to a change in the primary long-term trend.

10-year Treasury Yield Index -- Nine Day
Click here for larger image.
Source: TC2000

Looking at the daily chart below, you can see that over the past year rates have been building a solid base between 3.4% and 4.2%. You can also see that throughout September and October each correction built lower lows on the chart. That means that as the chart pattern tightens up, the possibility increases for an upside breakout. The key would be to watch for a breakout above 4.3%.

10-Year Treasury Yield Index -- Daily
Click here for larger image.
Source: TC2000

Now, the key to profiting from this trend would be to use an inverse government long bond index like the Rydex Inverse Government Long Bond Strategy Fund ( RYJUX). The daily chart of the RYJUX below also shows that throughout September and October each correction has built higher lows and the prices nearing the resistance levels that have been built throughout 2008.

If the 10-year breaks out above 4.3%, this fund can break above $18.15, and there is a good chance that we will at least test the highs made back in June 2007. A break above that level would certainly mean that the primary long-term trend has changed from down to up. If this fund breaks back down below $16.50, I would liquidate the position.

Rydex Inverse Government Long Bond Strategy Fund
Click here for larger image.
Source: TC2000

At time of publication, Manning was long RYJUX, although holdings can change at any time.

Mark Manning, AAMS, is an Accredited Asset Management Specialist and Registered Investment Advisor with Butler, Wick & Co., where he specializes in wealth management. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Manning appreciates your feedback; click here to send him an email.

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