Thursday, August 8, 2013

Bonds reflecting economic news

Bonds have been in retreat-mode for the last few months. The daily chart of the 10-year note shows support at 132 gave way earlier this year, followed by a break through 130 near the end of May.

The T-bond proceeded to selloff fairly dramatically, approaching 124 before reverting and holding at its current 126 level.

The weekly chart below depicts the longer-term rising trend line for the 10-year, which is still intact -- for now. If the T-bond were to get below 124, the trend line would be breached. 

As it is, longer-term support appears to exist at around 125. Also, note in the chart what looks to be a bearish head-and-shoulders formation (blue circles), with a plunge through the neckline in May -- foreboding. 

This recent weakness in bonds can be attributed to continued signs of strength in the economy, with the unemployment rate now down to 7.4% and the recent manufacturing PMI number shooting up to 55.

U.S. Unemployment Rate
(Source: Bloomberg)
(Source: Bloomberg)

The better the economic news, the more likely the Fed begins to taper sooner rather than later. It's assumed less QE will translate into higher interest rates, a belief that's putting pressure on bonds. 

However, another potential reason for bond weakness in the face of encouraging economic news is bondholders sell in favor of reallocating funds to riskier assets, such as equities. Many are asking the simple question: if the economy is improving, it should benefit companies/stocks so why continue to hold bonds?

To further illustrate the recent bout of good economic news, the chart below shows the Citigroup Economic Surprise Index for the U.S.

Citigroup Economic Surprise Index - U.S.
(Source: Bloomberg)

The Index is a composite that measures the degree to which economic data is surpassing expectations. When the Index is rising, economic data is coming in better-then-expected and vice versa, a declining Index means data has been disappointing. As shown in the chart, the Index bottomed in early June and successfully broke through its declining trend line last month, ripping higher in just the last few weeks.

The directional relationship between bonds and economic news can be seen more clearly in the chart below.

Source: Bloomberg

When the Citigroup Economic Surprise Index (upper inset) is rising and/or above zero, bonds (TLT, lower inset) tend to not fare well. And vice versa, when the Index is declining and/or below zero, the TLT tends to do much better.

As already mentioned, bonds remain in a longer-term uptrend, but just tenuously. And I would point out that when the Citigroup Index first turns positive -- as it did recently in significant fashion -- it tends to stay positive for some time. That said, and assuming this tendency plays out once again, bonds are likely to remain under pressure in the near future.

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