The US bond market appears once more at a critical juncture. This week I will look at bond price action, spreads and some ratio charts to see what we can glean from the data. This will also have implications on the stock market.

Bond price action

Lets examine price action first. Below is a daily chart of the traditional bond contract (ZB) with an elliott wave count applied. Although this is the most liquid and most widely analyzed of contracts, it is not the best in terms of price action due to the definition (15-25 years), which results in a sliding of the cheapest to deliver contract and a steep jump in duration when we roll to June contract.

It is beyond the scope of this article to explain, but we will look at other contracts below as well.

ZB daily chart

On the relatively short duration we are looking here, the distortions arent as radical. Furthermore, I am using prices that are adjusted for roll. I can clearly count 5 waves up of the lows in 2013. However, even though the wave count is complete and even displays a nice fibonacci relationship within it, we are still not seeing the ultimate confirmation of a reversal. The overlap within the structure looks like an ending diagonal.

Yield spreads

The 30y 10y spread has seen a significant correction. The falling wedge broke down, which is quite bearish for the spread. Furthermore, the topping formation, the support from the 2008 low in the spread and the long term spread channel all meet at about 0.3%-0.35%, which means that the spread between 10y and 30y yields might see this range eventually.

30y 5y spread

When we examine the 30y 5y spread however, we can see that we have already reached the equivalent target. Obviously we see some kind of disconnect between short term yields (suszeptible to expectations of tightening) and long term yields (driven by market fundamentals).

Meeting the target in the 30-5 spread could bring about a retracement of the spreads. This could easily be accomplished by a sell-off in the longer duration bonds, so lets look at the yields themselves.

Yields

Yields have been on a 30 year long slide, and despite the many calls for a sharp reversal, we havent seen it yet. The 10 year yield sits below 2%, which many economists feel is extremely cheap and only can go up.

To put this in perspective however, the German Bund (10y) yield is currently 0.5% and the JGB (Japanese Bond) yield is currently 0.28%. So we should keep an open mind about the extremes.

30y yields, weekly chart bullish triple bottom or bearish descending triangle

The 30 year yield looks to these eyes like a descending triangle, which has bearish implications. However, the projected target is very low and the energy indicators seem to indicate that this current down move is nearing an exhaustion period.

The opposite theory (bullish triple bottom) is also supported by the pattern in the 10y yields (not shown) that could resemble an inverted head and shoulders pattern (also bullish).

30y yields, monthly chart

The stock market (and in extension most tradable markets) is a tool to transfer money from the many to the few. This means we should also consider the greatest pain outcome. I thus believe that the greatest pain will be caused by a new low that is quickly reversed to set up a spring in yields.

This is consistent with the exhaustion in energy (see fractal energy indicator on chart) and with my overall expectation.

Carry trade in bonds

One of the most fascinating ideas and the root cause for the sometimes bullish positioning of many bond traders is the carry trade. Bonds pay interest and with the cheap borrowing rates of today, it has been a windfall for banks (and in extension bond traders) to borrow cheaply on a short term basis and invest that money in longer duration instruments while pocketing the difference.

As individual traders we can easily participate by buying and holding bond futures contracts, which have the borrowing built-in (through cheap futures margin).

Since the yields are currently near their lows again in the 30y contract, we can generate a good visual representation of the carry trade. Using the continuous bond contract and adjusting for roll, we can compare the difference in price between the two instances in time, which will exactly equate to the profit from the carry trade (in other words, how much we made investing in 3% instrument while borrowing at 0.25%).

Ultrabond carry trade visualization

I am using the Ultrabond contract due to the oddities with the traditional contract I mentioned above (which would result in overly optimistic results).

In the nearly 2.5 years since the 2012 low in yields, we would have made $5.5k per Ultrabond contract. Not too shabby, considering we bought the exact low in yields. However, the drawdown that we had to sustain was about $37.6k/contract.

Therein lies the danger in the carry trade at the current low yield. Even though we might still go lower and bonds might still not be done rising, a sharp reversal in yields will again result in a significant drawdown. And even though the carry trade will over time make up for that again, the carry trade can only compensate for a very modest rise in yields.

The risk/reward in the bond trade doesnt look nearly as compelling this year as it did at the beginning of last year, even if the Fed will not tighten. Even though I do not personally believe in a quick reversal of the 30 year bond bubble (but rather a process), I would prefer to wait for a better entry than this.

Some ratio charts

SPY vs TLT

Looking at the ratio between SPY (proxy for S&P500) and TLT (proxy for the traditional bond contract), we have broken the uptrend in 2014, which is a clear warning sign for the market in general. We can also see that for 2014 bonds did in fact outperform the stock market and that doesnt even include the total return for both, which will tilt the scale even further in favor of bonds.

When we compare SPY to EDV (proxy for the ultra bond), we can see a similar pattern, except that we already fell through support. Patternwise the outperformance of the bond funds looks corrective, which could be a wave 4 correction. This would work well with the expectation of a rise in yields in the intermediate term. In the short term however, we could see still a final hurrah in the bonds and an undershoot of these patterns.

Rate sensitive markets

Utilities have broken their under-performance trend. We are making higher highs and higher lows. Utilities are a defensive market play, so this divergence might be a bit troublesome for the markets. We should keep an eye on it.