Tuesday, March 24, 2009

Treasury Yields: Intervention Breeds Uncertainty

For many months, I have been tracking US Government 10 year Treasury bonds essentially stating that they have topped out. In my most recent article on Treasury bonds, I stated: "the upside for Treasury bonds is limited, and there is a high degree of certainty that a new secular trend is developing that favors higher yield pressures. "

The Fed's announcement last week to invoke the nuclear option and buy $300 billion of longer term US Treasuries over the next 6 months crushed yields-- easily causing the greatest (>14%) one day drop in yields on the 10 year bond in over 50 years. Despite this spike down in Treasury yields, it is still my belief that Treasury bonds are dead money. Noted market analyst, Marc Faber, editor and publisher of The Gloom, Boom & Doom Report, states that "the government bond market is a disaster in the making." As I see it, the new secular trend of higher yields has NOT begun, but I don't believe bond prices are attractive either.

I have discussed the technical picture in the past, and this has not changed. Looking at a monthly chart (see figure 1) of the 10 year Treasury yield (symbol: $TNX.X), we note that price fell out of the channel, but over the past 3 months, it has clawed its way back into the channel. This is constructive price action. The indicator in the bottom panel looks at the current price relative to past pivot points, and the indicator has broken its down trend line.

Figure 1. 10 year Treasury Yield/ monthly

What kind of price action would reverse the trend? It appears that a monthly close over 33.5 would be necessary. This would be a close over prior resistance and the 10 month moving average. Such price action would likely catapult prices out of the down trend channel. For those desiring to speculate on the possibility of a trend change, this may be an opportune time to build positions. With yields within the lower part of the channel, the risk is very small and very well defined.

Fundamentally, Treasury bonds are attracting less attention from sovereign wealth funds. This dynamic appears likely to continue because yields are very depressed (especially in the face of this country's current liabilities) and because foreigners have their own economic issues to contend with. The absence of a "natural" buyer should cause yields to rise thus making bonds more attractive. However, with the Fed now filling the void, it is not clear how this manipulation will effect the government Treasury market.

In England, central bank purchases of government bonds has not succeeded in lowering borrowing costs, and as this article from Bloomberg highlights, this is casting doubt on quantitative easing. Obviously, this is early in the ball game with the possibility of throwing more money at the problem if the first round of quantitative easing doesn't work.

The Fed's expansion in its balance sheet appears to be inflationary, and the creation of fiat money will put pressure on yields. As Faber states: "what it amounts to is money printing and in fact I don’t think that it will help the bond market at all in the long run."

Lastly, I have also discussed the fact that yields are unlikely to rise during a recession, and this may keep a lid on Treasury yields.

So let's summarize. Bond yields are poised for a secular trend reversal. However, market dynamics and interventions are creating uncertainty and artificially low yields. Natural buyers (foreign governments) have been replaced by the Fed. Balance sheet expansion should lead to higher yields especially if the economy reverses course.

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