Is the Bond Rally Over?

The massive rally in Treasuries that has occurred over the past five months mirrors the six-month rally in the second half of 2008. Both were flight to safety rallies.

In 2008 the rally was in reaction to the fear that the world financial system might collapse. The 2010 rally has been in response to a combination of sovereign debt risk in countries such as the PIIGS (Portugal, Ireland, Italy, Greece and Spain) and fears of an extended period of deflation. The deflationary fears have been fanned by talk of a double dip recession.

The similarities between the rallies can be seen in the following graph of TLT, the ETF for long term Treasuries (iShares Barclays 20+ Year Treasury Bond). The 2010 rally might be named 2008 rally lite.

Other indicators in the graph show similarities and differences between 2008 and 2010. At the top of the graph, the RSI (relative strength indicator) the overbought region above 70 was breached for about six weeks in 2008 and actually reached all the way to 85.

In 2010, the 70 level was just barely breached and only for about a week. The MACD (moving average convergence divergence) indicator at the bottom of the graph shows similar spikes and declines, with 2008 obviously making much larger swings than 2010. The technical indicators both mirror the price chart: all three portray a weaker move in 2010, but with parallel characteristics.

If the 2008 scenario were to play out in 2010, a brief rally now would be followed by a further drop. The rally and the second drop would be rapid, playing out over a period of a few weeks. For complete follow through of the earlier pattern, TLT would decline to the region between 86 and 92 over the next 4-6 months.

The completion of the pattern is likely if:

1. Fears of a recessionary double dip recede;

2. Sovereign debt problems stabilize; and

3. Deflationary expectations lessen.

One thing to watch in trying to decode the bond market is GDP. There are some weak to fair correlations between GDP and the movement of bond prices. In the following graph, quarterly change in TLT is plotted on the y-axis vs. quarterly GDP growth change on the x-axis.

There are five data points with TLT price gains greater than one standard deviation above and four data points one standard deviation below the trend line. Of these, we have three pairs where one data point is a positive outlier associated with an adjacent quarter (or one quarter removed) data point which is a negative outlier. These pairs are 2Q/2003 and 3Q/2003; 1Q/2004 and 3Q/2004; and 4Q/2007 and 1Q/2008.

That leaves only 1Q/2006, 4Q/2008 and 2Q/2010 as outliers without a balancing opposing outlier. We do not know if the 2Q/2010 outlier will have a balancing outlier in the coming two quarters. If we omit the six outliers that are paired off and the 2Q/2010 data point for which status has yet to be determined, the correlation improves considerably to -0.65, which is a weak negative correlation, approaching the boundary of fair at -0.70.

If you anticipate that the current quarter will have real GDP growth weaker than the prior quarter, there will be a tendency for Treasury bonds to rise; you could buy TLT. If you anticipate real GDP growth will be stronger than the prior quarter, there is a tendency for Treasury bonds to decline; you could buy TBT (ProShares UltraShort 20+ Year Treasury). However, the correlation study indicates that the tactic has worked only about 2/3 of the time, so investors must monitor the market and have a loss limiting strategy for the 1/3 of the time when the correlation doesn't work.

The Treasury market may not only retreat to prices of early 2010 but might fall far further if GDP growth turns back up. A couple of quarters of annualized real GDP growth above 3% could drive TLT down to prices between 70 and 80.

Guy Lerner at The Technical Take has a bullish view for bonds at this juncture. His chart for TLT is shown above.

Lerner feels the market is presenting a buying opportunity here. But he warns that if the green support line is violated his bullishness will be reversed.

TLT has traded in the range of 101.85 to 102.79 today (Friday, September 10) and closed at 102.32, down 0.47 from Thursday's close. So far Lerner's support level has held.

Disclosure: No positions in Treasuries other than TIPS (Inflation Protected Securities).

John B. Lounsbury is a financial planner and investment adviser, providing comprehensive financial planning and investment advisory services to a select group of families on a fee-only basis. He worked for 34 years with IBM, and spent 25 years in R&D management and corporate staff positions. He also was a Series 6, 7, 63 licensed representative with a major insurance company brokerage for nine years.

Specific interests include political and economic history and investment strategy analysis. He holds degrees from the University of Vermont, Columbia University and the Illinois Institute of Technology, where he studied chemistry, physics and mathematics. He is a contributor to Seeking Alpha and his own blog, PiedmontHudson.

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