How Low Can Bonds Go?

Bond yields have jumped in recent weeks due to an increasing supply of Treasury debt and strength in US equity prices. The increased supply of US debt instruments suggests that yields will have to climb to attract investors. China is rumored to have shifted its holdings of US treasuries from long dated Notes and Bonds to shorter-term T-Bills, which could have aided the steepening of the yield curve. Today’s 10-Year Note auction has put pressure on Note and Bond prices in the early going, which is common ahead of auctions. Yields on the 10-Year have climbed to 3.88 percent. Equity prices have remained strong, diminishing trader demand for treasuries. The sharp upturn in commodity prices in recent weeks hurts Bond prices on two fronts. First, traders seeking safe haven investments are flocking to physical commodities, such as precious metals, at the expense of treasuries. Secondly, higher commodity prices suggest inflation is increasing at a higher pace than previously expected, making Bonds unappealing as investments.

The prospect of rising inflation also suggests that the Fed may be forced to raise interest rates later this year. The corporate bond market has shown significant improvement in recent months, with new issues of corporate debt increasing at a steady pace. Investors have shown an increased appetite for higher yielding corporate debt over treasuries. Also, issuers of new debt short the treasury market ahead of new issues to hedge yields. All of the previously mentioned factors have significantly pressured the price of the 30-Year Bonds, but traders have to be asking themselves if this pattern can continue. It is difficult to see the trend reversing course in the foreseeable future unless there is a major shift in fundamentals, such as a sharp sell-off in equities or a material regression in economic indicators.

Another outside market force that could affect interest rates would be the mortgage market. Low interest rates have created a refinancing boom, which has aided the recovery in the banking sector. Higher interest rates could adversely affect the mortgage market and stall the fledgling recovery in the housing market. There are signs that higher interest rates have already made an impact on the mortgage market, with the Mortgage Bankers Association showing mortgage applications dropping 7.2 percent for the week.

Trading Ideas

Seeing that the market is reaching a critical support level, some bearish traders may wish to wait for confirmation in the form of a solid close below 111-27 before entering the short side of the market. Traders that are neutral to bearish, however, may possibly choose to explore entering a bear call spread. An example of one such spread would be selling a Sep Bond 121 call (USU9121C) and buying a Sep Bond 123 call (USU9123C) for a credit of 0-32, or $500. The maximum risk on the trade is approximately $1,500.

Technicals

Looking at the continuation chart, Bonds are coming up to several key support levels. Prices have already tested the October low close of 113-015 in early trade and have held the level to this point. The June low close at 111-27 is critical, as solid closes below this level could signal additional selling pressure, as longs would likely get squeezed out of the market. Holding this close, however, may be a sign that the market may correct or enter a period of consolidation. On average, volume on down days has exceeded that of up days, suggesting the downward trend is not letting up. The RSI indicator is now at oversold levels, which is of major technical significance. Typically, this can be seen as a somewhat supportive indication for the market, as it could signal traders may take profits. On major breakouts, however, the RSI indicator behaves inversely. If key support is broken on oversold conditions, it could be seen as a particularly strong bearish signal