Long Bonds and the Yield Curve
by Jes Black
February 02/05
Two weeks ago we said to look for one final rally in the S&P 500 as long as the 1160 level held up. It is not lost on us that once again stocks show they can only rally if long term yields and the dollar are not rising. But this trend should soon come to an end.
Below we feature our “investment nirvana” theme that depicts when investors fear neither stock market losses nor inflation. We represent this by dividing the T-bond by the Vix. Recall that in December 2004 this ratio tested its all time high of 10 seen exactly ten years ago in December 1993. Importantly, the previous top coincided exactly with the Fed’s rising interest rate cycle that began in February 1994 after having held rates at 3.0% for 17 months following a rate cutting cycle that began in July 1990 at 8.0%.
Note how there was a final surge in T-bonds as the steepening yield curve
reversed direction and began to flatten. Then, when the ratio between
the 30-year bond yield and the 3-month money market fell to 2 (30-year
at 6% and money market at 3%) the bond market peaked and began to head
sharply lower. This coincided with a peak in the Bond/Vix ratio as well.
Interestingly, the exact same set up is occuring now in the Treasury bond.
When the yield curve peaks many traders buy long dated bond and sell shorter
maturity bonds. This was the primary reason long bonds rose in 1993 while
short-term bonds fell.
Similarly, the T-bond to Vix ratio has retested its all time high of 10 while the yield curve has flattened over the past twelve months. During this time the long bond has rallied while the market anticipates higher rates and has pushed up the the 3-month from 0.9% to 2.46% in less than a year.
The only difference between now and then is that the yield curve peaked and headed sharply lower in October 1992, fourteen months before the Fed first raised rates to 3.25% in February 1994. This time the yield curve did not begin to flatten until the Fed’s first rate hike in June 2004.
If we focus only on the turn in the yield curve itself we see that the eight-month rally in T-bonds is identical to the 1993 rally in the sense that it is mainly a result of traders playing the yield curve after it peaked and began to flatten out.
With a Fed funds rate of 2.5% still extremely accommodative there will
be ample room to raise short-term rates but little room left for traders
to play the curve. Therefore, we should see a substantial decline in the
long end of the bond this year as this artificial support for US long-term
debt subsides. This provides an excellent opportunity for those bearish
on long bonds.
Note: You can read our strategy report on US bonds in this month's issue
of Futures magazine.
Moreover, reall that our research report from last week showed that the
ratio of shorts to longs held by commercial hedgers, aka smart money insiders,
in the 30-year bond reached an all time high in December, eclipsing the
high seen in 1998 before bond prices collapsed and occured in conjunction
with the all time high in the bond to Vix ratio.
Therefore, we feel that this bond rally is very susceptible to a spill
as the yield curve ratio has flattened to 2 - exactly the same point when
bonds prices peaked in 1993.
Jes Black
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Jes Black, hedge fund manager at Black Flag Capital Partners, specializes in foreign exchange and global macro trends. Prior to organizing the fund he helped MG Financial Group launch Forexnews.com. Afterwards he went on to found FX Money Trends, a research firm catering to professional traders.
Mr. Black holds a degree in economics from the University of Kansas and
an MBA from the ESC in France. His market commentary is often featured
in the Wall Street Journal, Financial Times and Reuters. He has also written
numerous strategy pieces for Futures magazine. To find out more about
the fund’s research letter visit www.fxmoneytrends.com. Qualified
prospective investors can find out more about Black Flag Capital Partners
by e-mailing info@blackflagfund.com
Jes Black
FX Money Trends, LLC
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