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posted on 05 July 2017

Waiting For The Bond Bears

Written by , Clarity Financial


During the last week, we finally got a bounce in interest rates from very oversold levels (remember rates are inverse to bond prices so oversold rates = overbought bond prices.) I am patiently awaiting the “bond bears" to come out in force once again declaring the “bond bull market" dead and telling you why you should sell your bonds and buy overvalued stocks.

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This has been the case since mid-2013 and all along the way, through numerous missives, I have explained why such an outcome will not be the case. To wit:

“As I have discussed many times in the past, interest rates are a function of three primary factors: economic growth, wage growth, and inflation. The relationship can be clearly seen in the chart below."

“Okay…maybe not so clearly. Let me clean this up by combining inflation, wages, and economic growth into a single composite for comparison purposes to the level of the 10-year Treasury rate."

“As you can see, the level of interest rates is directly tied to the strength of economic growth and inflation. Since wage growth is what allows individuals to consume, which makes up roughly 70% of economic growth, the level of demand for borrowing is directly tied to the demand from consumption. As demand increases, businesses then demand credit for increases in capital expenditures or production. The interest rates of loans are driven by demand from borrowers.

Since ‘borrowing costs’ are directly tied to the underlying economic factors that drive the NEED for credit, interest rates, and therefore bond values, can not be overvalued. Furthermore, since bonds have a finite value at maturity, there is little ability for an overvaluation in the ‘price paid’ for a bond as compared to its future ‘finite value’ at maturity."

The last sentence is the most important. There is a point to where bond prices lead to a negative rate of return. At that point, a bond buyer will only buy bonds with the expectation rates will become even more negative. In such an environment, really BAD things are likely progressing economically.

That is an analysis for another day. For now, we are looking for an opportunity to increase our exposure to bonds opportunistically.

As I addressed in last week’s sector analysis:

“As expected a couple of months ago, rates fell as the economic underpinnings failed to come to fruition. However, with rates now extremely oversold (inverse of bond prices) bonds are now extremely overbought. Look for a pullback to support on the index to $125 to add bond holdings back into portfolios. There is no reasonable stop currently for bond trading positions so caution is advised."

The chart below is updated from last week:

As shown, that call was timely, and bonds pulled back to the first Fibonacci retracement level of $125. However, bonds are not yet oversold. Therefore, we will hold off on adding to existing bond exposures, or adding new positions, this week with the expectation rates could rise a bit further. The chart below is the 10-year interest rate. The current target for this reflexive rally is 2.3% in the current downtrend as rates head back towards 1.9%.

From a technical basis the trend lower from the recent peak at 2.6%, the spike was driven by China selling bonds in an attempt to stabilize their currency, remains firmly intact. When the economy slips into the next recession, interest rates will once again join the long-term downtrend towards 1% or less.

So, as I stated, we are looking to BUY bonds…but at the right level.

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