GET READY FOR RISING RATES, FALLING BONDS / BARRON´S MAGAZINE ( A MUST READ )

Get Ready for Rising Rates, Falling Bonds

By MICHAEL KAHN |

The financial markets are voting for higher rates on long-term Treasuries. And don't be surprised if the Fed ups short-term rates later this year.

One of the most famous saws in all of investing is "Don't fight the Fed."

If Chairman Bernanke and company is on a mission to keep short-term interest rates low, then stocks typically benefit from the gushing fountain of liquidity.  

However, there is one entity on the planet that can and does fight the Fed - the market itself. If the market decides it wants to push interest rates higher, then up they go no matter what.

Given the action over the past week, the Treasury bond market has started to make a move. We cannot call it the end of the 30-year trend towards lower interest rates, but it is the necessary first step in making that change.

The near-term trend in market-driven interest rates is now to the upside.
Interest rates, which move opposite from Treasury bond prices, have made technical breakouts across the maturity spectrum. And now the fed funds futures market is placing bets that the Fed itself will have to bump up short-term rates by year's end.

Traders are bidding up the implied yields of futures contracts expiring several months down the road and usually they are right.

I'll leave the economic implications of rising rates to others to ponder. In the bond market, the days of the tireless bull in prices and bear in rates are long gone. Indeed, prices broke down and rates began to move up in early November (see Chart 1). The benchmark 10-year Treasury note dipped below its rising six-month trendline and fell rather sharply for several weeks.

Chart 1

10-YEAR TREASURY NOTE FUTURES

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Throughout much of December and January, the market stabilized, forming a pattern chart watchers call a rising wedge. It is simply a counter-trend move, typically on lower volume, that presages another bout of falling prices ahead.

One month ago, the title of this column was "Bonds Nearing Major Crossroads on Charts" (see Getting Technical, January 4). With the breakdown from the wedge pattern, the 10-year note has told us that it is seriously thinking about moving down to major chart support in the 115 area from its current 118, in round number terms.

If that were to happen then interest rates on the 10-year would move to the 4% level, which is a critical area on the charts from both technical and psychological points of view (see Chart 2).  If rates were to rise appreciably above that level then we would have a confirmed bull market in interest rates and bear market in bond prices. It is indeed an important crossroads.

Chart 2

10-YEAR TREASURY INTEREST RATES

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In the corporate bond market there is a strange dichotomy. Investment-grade bonds, those with ratings of Baa and above, are falling in price in similar fashion to Treasury bonds. High yield, or junk bonds, on the other hand, are now trading near two and a half-year highs.

In other words, quality corporate bonds are once again tracking Treasuries as they have done for years. Junk bonds are trading more in line with stocks as investors scramble for yield. If money market funds are returning near zero yields stocks and stock-like instruments enjoy higher demand.

When discussing the potential for a major shift in the trend of interest rates, we have to take a look at the big picture. A monthly chart of 30-year Treasury bond futures shows a multi-decade trendline now coming into view from below (see Chart 3).

Chart 3

30-YEAR TREASURY BOND FUTURES

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The trendline drawn in the chart begins at the bottom of the 1993-1994 cyclical bear market and if extended back in time comes close to the generational low in bond prices set in 1981. In other words, this trendline defines a secular bull market and prices are now heading down to challenge it.

Until this long-term indicator is broken to the downside, bond-market bears and interest-rate bulls can only claim minor victory. However, the bond market is making a statement now that it is getting restless. No amount of intervention can stop it once it makes up its mind.