It was a nice run for bond bulls, but the gravy train is now over. The good news is that the recent spike in interest rates is thus far contained and has not broken any major technical levels.

The 30-year Treasury bond rallied about 38% in price from the 2013 low to the high in July 2016, and in the bond market that is a huge move. What was more impressive was that it also defied the pundits who saw interest rates heading higher in an improving economy, albeit slowly, and a market in fear of Federal Reserve policy unwinding.

But the trend in price changed from up to down and after a four-month slide the market dropped even more sharply after Donald Trump’s victory. In just a few months, bonds surrendered more than half of their gains in the previous two-and-a-half-year rally (see Chart 1).

Chart 1

While oversold in the short term, it is still quite dangerous to attempt to bottom-fish this market as we can see in a long-term chart. We can better see just how much room is left to go before technical levels come into view.

The 30-year yield topped 3% last week as it continued its climb. The question is how high can it go without creating a major, and I do mean major, shift in interest rate direction. A trendline drawn from the 1994 high, which was the end of a significant rise in yields at the time, is near the 3.5% level and still falling (see Chart 2).

Chart 2

Extrapolating the current advance forward, and that is based on nothing more than an experienced guess, I would expect the rally to hit the trendline in the 3.25% area in three or four months. There is also resistance there on the charts from the 2015 high.
While this is a big move in percentage terms it would still be nothing more than a test of the long-term declining trendline. In other words, just a part of the normal ebb and flow in any market. The problem will be if rates move through the trendline, but we don’t have to think about that now.

I look at the 30-year yield instead of the benchmark 10-year yield because it is more of a pure play on interest rates. Secular changes in interest rate trends should be more apparent at this maturity. However, with that said, the chart of the 10-year yield has a greater percentage distance to travel before meeting its long-term trendline (see Chart 3).

Chart 3

It is hard to make a point-by-point equivalency between charts of the two maturities.

Therefore, I see the 10-year moving to the 2.6% level, overshooting its next resistance level and getting close to its trendline a few months from now.

Again, that is hardly the end of the world and might actually benefit economic growth and investment in general. True, current holders of bonds and bond equivalents in the stock market, such as utilities, would get hurt. However, higher interest rate levels would suggest something closer to “normalcy” in the yield curve and that would be a good sign for the economy.

Let’s examine the yield curve using the spread between the 10-year yield and the two-year yield, a widely followed metric.

I last wrote about it here in January as the spread dropped to what looked to be a major support level (see Chart 4). A narrow spread means the yield curve is relatively flat. Taken to the extreme of a completely flat or even inverted yield curve, that usually indicates a recession is likely.

Chart 4

The spread continued to fall but never got close to where it was in 2007 at the start of the last recession.

However, in late August it picked itself up to rally back to the level I highlighted in January.

Chartists think this is a “test” of the breakdown and a crossroads for the market. If the spread fails here and heads back down I would not be surprised to read about the pending recession.

But if it rallies through that level, then we have to take it as a good sign. Indeed, the spread has already broken through a three-year trendline to the upside.

Again, the rise in interest rates seems scary but any long-term problems are not yet indicated.

The shift in the yield curve, however, could be a good sign so we will have to see what happens to the two-to-10 yield spread as we head into December and a presumed rate hike by the Fed.