US Treasuries - a long term view
Daan Joubert
Introduction
Fund managers and others who earn a living from extracting funds out of the pockets and savings accounts of the average guy on the block are fond of the saying that to 'buy and hold' is really a good strategy. At a rough guess 70% of the time history will prove them right quite soon. The other 30% of the time history will also prove them right, provided the investor has the patience - and the life span! - to hold on for the 20-30 years before profits begin to materialise to the degree where the investment was worth making in the first place. This applies to both equity and bond markets.
One of the factors to consider when making 'buy and hold' decisions is to ponder on what interest rates are likely to be like over the first 2 to say 5 years or so of the period of the investment; a critical time during which the investment should appreciate at a good clip in order to provide a strong base for more steady growth later on. In this prospect the longer term yields are quite important as these point to expectations for inflation and to the degree of uncertainty and stress in the market. High yields equate to expectations of higher inflation and of greater uncertainty (and thus risk) over the near to medium term.
In the equity market high interest rates has a depressing effect on growth, while in bond markets high interest rates and thus high yields are inversely correlated with price.
The pre-eminent measure of long term yields is the US 10 year Treasury note. It is not only the benchmark for long bonds in many or most other countries, but also provides the main base against which US mortgage rates are set. Higher yields mean higher mortgage rates and therefore reduced incentives to purchase a new home - and even less incentive to refinance an existing mortgage. We know the latter is very important to sustain the high level of consumer spending which has been keeping the US economy in good shape; a good deal of the ready cash households have been splurging on new goodies (much of it being imported!) has come from the refinancing of mortgages. A significant reduction in refinancing as rates move higher would be bad news for the GDP bulls.
At the same time, lenders look at long bonds to estimate risk and when the yields on these bonds rise, they make their lending more selective - becoming more critical of the credit worthiness of their clients and raising their own rates. In a country where all kinds of debt - personal, corporate and government - are at record levels, any higher trend in rates is definitely not welcome and could prove devastating.
So what is the outlook for yields on the US 10 year note? Not this month or the next, but over the medium to longer term - the time span that would come into play with a buy and hold strategy, whether one is to invest in equities or in bonds.
Chart Symmetry
Previous essays have discussed the methodology I use for technical analysis. Briefly, for new readers, Chart Symmetry is founded on the observation that prices tend to reverse or change direction along certain preferred gradients. Such a gradient is revealed when a trend line is the locus of more, or more prominent, trend reversals one would normally expect. Once such a gradient is found, it will be seen that lines parallel to that gradient, at suitable points on the chart, share that characteristic of being the loci of a good number of prominent trend reversals.
Secondly, more than one such set of parallel lines, each of a particular preferred gradient, can be identified on the chart. It so happens the different sets of lines, i.e. the different preferred gradients, are related to each other through the Fibonacci ratio. Once one has identified a preferred gradient, other preferred gradients can be found by either increasing or decreasing the known preferred gradient by the Fibonacci ratio. Repeated applications of this transformation result in a fan of lines, all of them preferred gradients for that chart.
An analysis begins with the search for a good master line - a trend line that identifies a prominent preferred gradient. The search generally begins with trend lines that are major tangents to the price chart. Once such a line is found, the analysis proceeds with a search for chart patterns that would enable the analyst to draw conclusions on the likely future development of the chart. The search is done using parallel lines, inverted lines (i.e. with the same preferred gradient, but with opposite slope) and lines with different gradients as per the Fibonacci ratio.
The patterns one is looking for comprise the standard types well known to technicians for generations: channels, wedges, pennants, flags, triangles and megaphones. What is new in Chart Symmetry is that in the vast majority of cases the sides of these patterns happen to be preferred gradients that can be derived from each other. In other words, the gradient of one side of a triangle, say, can be derived from the gradient of the other side by using the Fibonacci ratio. This enables a very accurate analysis of chart patterns and enhances the confidence with which the results of the analysis can be treated.
The long term history of the yield on the US 10 year Treasury note, when subjected to Chart Symmetry analysis, delivers some very interesting results.
The analysis
The analysis is performed on the monthly closing values of the yield on the US 10 year note, presented as a linear chart. The first chart shows the selection of the master line, M, which was generated through the two points market with an 'x'. Line M is the tangent to the 1950's - 1980 long term bear market in US bonds.
Lines F1 and F2 are the first and second shallower derivatives of line M. They were generated from two significant lows in the yield, each identified with an 'o'.
Line F1, generated from the first significant low, passes through the chart and picks up a number of major reversals with good accuracy, key characteristic of a preferred gradient. The change in gradient of line F1 from that of M and also from F2 shows the spread one obtains between gradients when the Fibonacci ratio is used.
M-F2 is a widening formation, or megaphone, with F2 as major market resistance line of the early part of the history; the yield rebounding off F2 on three occasions during the decade of the 60's. Keep in mind that the gradient of F2 is determined by the gradient of line M; F2 was not 'selected' by the analyst as the line through the series of early lows.
Much later, during the bull market of the 80s, the yield again intersects line F2. At first there was a significant overshoot and then the yield corrected to play around line F with at least one and possibly more reversals reacting along that gradient. This first analysis is not of any value for forecasting; it is used to illustrate the basic principles of how Chart Symmetry is used - the use of the master line and the generation of freestanding derived lines at various suitable points on the chart.
Apart from the good fit to F2 during the 1960's, which confirms the fact that line M is in fact a preferred gradient, there is nothing startling in this analysis. However, this changes when we bring in some new lines, the inverse of lines M and F2, in the next chart, which shows a more complete analysis.
Inverse lines - lines with the same gradient as a known preferred gradient, but which have an opposite slope - play an important role in the isolation and identification of chart patterns that can be used to explore the potential for the future behaviour of the price.
In the chart below lines A-B-C are the inverse of line F2; they were generated from the points on the chart marked with an 'o'. Line I, the direct inverse of line M, was generated from the top of the chart. The accurate fit of lines C and I in particular is striking, while the equal spacing of lines A-B-C is typical of preferred gradients in Chart Symmetry.
Interpretation
Pattern I-C is quite clearly a very large pennant - a typical continuation pattern that is well known to technical analysts. Unfortunately the count of the legs within the pennant is complicated by the fact that what seems to be leg 2 - the descending leg out of the very top - does not fully reach line C; it comes close but there is no touch. Yet, if we assume that leg 2 is complete at that point, we find an excellent fit at the ends of legs 3 and 4, with the most recent weakness in the market completing leg 5 of the pattern.
In 80-85% of cases a narrowing formation, such as this pennant, completes normally. Here the expected break should be upwards. A first target of a break higher would be market support at line B, currently at a value of 6.57%, as shown in the table at the top right. If that support does not hold, the next level of support would only kick in at line A, currently just a little below 10%, but likely to be substantially lower by the time the support is reached.
The traditional rule of thumb for pennants and triangles is that the extent of the move out of the pattern should equal the length of the 'flag pole' - the initial rising trend, in this case, on which the pattern is suspended. Since the starting point of the current rising trend is quite similar to that of the 'flag pole', one can surmise that the final target for the new bear market that have already started and is to be confirmed by a break higher above line I (currently at 4.52% for the monthly close), should be close to the 1980 high, which implies a yield of well over 15%.
Conclusion
This is a long term view of the US bond market. If the presumed target lies near or over 15% - a truly frightening prospect - the consolation is that this high value is not likely to be reached this year or the next; or even within the next 5 years; although some of the intermediate targets shown in the analysis are almost sure to have been tested by then.
However, the recent weakness in the market has already taken some 25% off the value - the price - of the US 10 year note. Investors who bought at the bond market high are twice as badly off as buyers of equities at the top of the Dow Jones index, currently down 'only' 11% on a monthly close. Should the yield break higher from the pennant to reach support at line B, the price of the 10 year would have halved from the market high, while people who buy at this time would be losing about one third of their investment.
Obviously, as the yield moves even higher, their losses would mount further.
Of course, technical analysis is not a crystal ball that by itself predetermines the future. But experience has shown that basic patterns - such as the pennant - in a large majority of cases are followed by developments in the price that are anticipated by the presence of the pattern. In this particular case, the pennant anticipates yields on the US 10 year note that hold dire implications for the US and the global economy.
10 August 2003
© 2004 Daan Joubert
All rights reserved
daanj@kingsley.co.za
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