10-Year Bond Rates

If you look at the 10-year bond rate since the end of 2008, the economic free fall, until the present time, you see several interesting and informative behaviors. First, when the economy was in potentially serious condition in November and December of 2008, rates gapped down on several occasions. This means that bond price gapped up on those occasions. Second, if we apply Fibonacci analysis to the bottom in rates at the end of 2008 up to the present time, you see that Fibonacci has been very predictive for likely declines from the recent 10-year peak of around 4% in June of this year. The chart below shows this (click to enlarge). Remember that the values on the right axis are 10x the interest rate, so 36 is really 3.6.

The 61.8% retracement level (around 3.27%) has been touched on several occasions. Note that the rate has yet to fall to the 50% retracement point (at 3.04%). While we remain slightly above the 61.8 percent mark, note that the RSI is still above the oversold reading of 30, so it is quite possible that we will see another retest of the 61.8 percent level at 3.27%. The likelihood of this rests on, among other things, markets continuing to believe the message delivered by Fed Chair Bernanke the other day.

What we have been witnessing in the short-term, however, is a rising stock market with a strong bond market. So, stock prices have been rising while interest rates have been falling. This is not the typical pattern. Usually stock prices and interest rates move in the same direction. You should think about this to strengthen your understanding of the stock and bond markets. The "other thing" that is not equal is the words of the Fed Chair.

I have recently heard some "talking heads" discuss whether the bond market is a bubble at present, while others are hinting that rates have gotten very high, potentially a cause for worry. I have plotted the 10-year rate weekly over a very long time period. The chart shows this from the early 1990s (click to enlarge). The current 10-year rate is hardly excessive based on its history, which showed it to be around 8 percent in the early 1990s. Note the long-term downward sloping resistance line. Were we to move up to that line, the 10-year rate would have to rise to 4.75 percent, which is approximately the level it attained during the double top in 2006-2007 (note: that double top is what converted me to using technical analysis -- the technical analysis prediction of a declining rate from that double top ran counter to the "traditional economic wisdom" of the day which saw higher rates coming). How likely is it for the 10-year rate to rest resistance at around 4.75 percent? Use the model of interest rates we have developed and enhanced from class:

r = f(expected inflation, autonomous spending components, monetary policy)

Remember: in place of economic growth in this model, you should now employ the Basic Keynesian Model which identifies factors that generate growth: changes in autonomous spending (from C, Ip, G, and NX). The resulting forecast will allow you to move well beyond the limits of technical analysis.

Follow Up to January Employment Report

I hate to say I told you so (in the previous post), but the market sold off sharply yesterday (Tuesday, 2/10) when Treasury Secretary Geithner presented his plan (actually, more of a broad outline). Who was particularly hard hit? Banking and financial stocks. What the stock market did yesterday is what it would normally have done on Friday after the employment report. Note that this large market decline occurred along with a very large volume -- indicating "conviction" in this move.

Sadly, this was fairly predictable, not only based on a "buy on the rumor, sell on the news" basis, but since so many of the "talking heads" on television had been trying to convince people that this was an excellent time to get back into the market. I have even heard speculation that had (and when) sufficient details been provided for the financial package the market would rebound. Only if the package ends disease, brings peace to the world, extends global life expectancy to 100+ years! In other words, any package will be imperfect, and market participants will find reasons to be less than enthusiastic.

There are two things I want you to focus on from yesterday. First, we witnessed a textbook example of a flight to safety (review this in the Supply and Demand notes), where persons fled stocks, lowering stock prices, and moved their money to a more safe place, the fixed income (bond) market, raising bond prices and causing interest rates to fall. In fact, the US 10-year bond fell significantly, by about 16 bp yesterday. Second, the Dow-Jones average broke well below 8,000, closing at 7,888. This moves us back to levels we haven't witnessed since mid-November. Don't expect any significant positive market momentum until we get some meaningful clarity on the financial program. In other words, I believe the market will move lower before rising -- we will test further support.

How far might the market fall? Let's rephrase that: where is the next level of support for the Dow-Jones? First, check where price is relative to the 50-day moving average. We failed yet again to break the 50-day, which has to be viewed as short-term resistance at this point. Also, the RSI does not indicate an overbought condition (<30).

Look at the ten-year bond ($TNX) and see how it reacted yesterday. After peaking at 3.05% a few days ago, which had an overbought reading from the RSI, that rate has fallen sharply, yesterday and today (thus far). Also, there was a gap down yesterday. Try identifying relevant economic factors that determine the behavior of the ten-year, determine how those factors will likely be changing, then make a prediction of how the ten-year rate will be moving over the next few days.