Encouraging Trading Pattern Emerges in Bonds and Rate-Sensitive Stocks

There are no coincidences, in life or in the financial markets, which is why the activity displayed on price charts is an important aspect of investing.

For example, as I write there is an encouraging trading pattern developing in the U.S. Treasury Bond market which is spreading to the interest rate sensitive housing and real estate investment trust (REIT) sector. Moreover, barring a major reversal due to the Fed’s most recent interest rate moves, this trading pattern may be forecasting an end to the higher interest rate cycle.

Bond Yields and Inflation

As I’ve stated here multiple times bond traders hate inflation because its presence eats at the real return on their bond investments. For example, the real return a bond which yields 5% is that which is left after accounting for inflation. Thus, if CPI is used as a benchmark, and it’s growing at a 7% pace, the real return on the bond is -2%.

Given that the post pandemic spike in inflation sapped the real returns on U.S. Treasuries, it’s no wonder investors have been aggressive sellers of key issues such as the U.S. Ten Year Note, whose yield (TNX) is the benchmark for large swaths of 30-year mortgages and other important business lending rates.

Most recently, TNX has reached levels not seen since 2007. Yet, as the price chart below shows, recent trading action suggests we may be at an important inflection point.

For stock investors, rising bond yields are usually negative, especially for the housing and REIT sectors which depend on low mortgage rates for their growth. Therefore, the current trading pattern may be a bullish development for those areas of the market.

The Long Term View

In previous posts, I’ve described the overextended nature in treasury bond yields displayed by TNX by noting that it’s trading above the normal boundaries of what is considered normal statistical price behavior. As you can see, TNX hit the 5% yield area recently. Moreover, in doing so, it rose above the blue line on the chart which marks the top of what is considered the normal long term trading range.

Plainly stated, TNX is currently trading at a point which would be more appropriate during a period of runaway inflation – think Argentina and Turkey, which is not the case in the U.S. In fact, recent data suggests that U.S. inflation has cooled, although its path toward past lower readings remains uncertain. Because of this softening in the data, a reasonable case for at least a partial downside reversal in rates can be made.

Bond traders have noticed this development, which is why TNX is now on the verge of breaking below that blue line, which is roughly at the 4.78% yield. A sustained break below that level could take TNX to 4.5% and perhaps lower, even toward 4%.

The current trading action could be happening solely for technical reasons. After all, the bond market is very overextended as illustrated by the recent RSI reading on TNX, which was well above 70.

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What’s more important is what may happen if inflation cools rapidly as in a traditional recession, or if something very dramatic happens in the world which triggers a massive flow of capital into U.S. Treasury bonds as a flight to safety unfolds.

In that case, rather than a steady decline in yields, we may see a rapid fall, which would be highly concerning.

The Trading Pattern

All of which brings me to the trading pattern I mentioned in the lede to this article, as is evident in the popular bond trading vehicle, the iShares 20+ Year Treasury Bond ETF (TLT).

TLT’s price is inverse to TNX as TLT reflects bond prices which fall when yields rise.

Specifically, note the following:

  • The top in TNX (above) roughly corresponds to the bottom in TLT;
  • TLT is currently oversold based on recent readings below 30 on the RSI (Relative Strength Indicator);
  • The oversold RSI reading for TLT corresponds to the RSI reading above 70 for TNX;
  • TLT recently made a new price low which was not confirmed by a new low in its RSI. This technical combination of circumstances usually signifies that downside momentum (selling pressure) has abated enough for prices to move higher;
  • The Accumulation/Distribution (ADI) for TLT line is well off its recent bottom. This is a sign that short sellers are covering their bearish bets, which in turn reduces downside pressure on prices; and
  • On Balance Volume (OBV) for TLT has bottomed but has not turned up convincingly. This suggests that buyers are not fully committing to the bullish side of bonds yet, but that they are less bearish.

In other words, short sellers are less bearish on bonds while buyers are not yet fully convinced that the risk/benefit ratio is currently in their favor. This combination is setting the stage for a market which will respond dramatically to news, such as what the Federal Reserve says or does next, the upcoming jobs numbers, and developments in the Middle East conflict.

The Stock Connection

If you doubt the connection between the action in the bond market and important sectors of the stock market, these next two charts should change your mind.

A comparison of the price charts for both the SPDR S&P Homebuilders (XHB) and the iShares U.S. Real Estate (IYR) ETFs to the price chart for TLT shows an excellent correlation between money flows in bonds and how they affect the price of real estate assets, which of course are highly interest rate sensitive via their connection to mortgage rates.

Note that as the ADI for TLT indicates that short sellers are bailing out on bonds, the same indicator is showing signs of bottoming out in both XHB and IYR, as the price for both ETFs is showing signs of bottoming out along with OBV as investors begin to price in a potential bottom in these interest sensitive sectors.

Bottom Line

Money is trickling back into treasury bonds and interest rate sensitive sectors such as homebuilder stocks and REITs as investor fear of rising interest rates shows signs of peaking. This potentially bullish scenario still requires further confirmation and may be fully reversed if the Federal Reserve says or does the wrong thing or extraordinary events develop somewhere in the world.

The upcoming jobs number and future readings on inflation (CPI and PPI) will also play a role in what happens next.

Yet after the short term reaction to any surprise or economic data, the long term economic and geopolitical issues which are unfolding are not showing signs of potential change. That means that traders will still have to deal with the housing shortage/affordability situation, the spending battles that loom in Washington, the likelihood of rising budget deficits around the world, the Middle East conflict, the ongoing war in Ukraine, the geopolitical interactions between Russia, China, and the U.S. and the intensification of the U.S. election cycle, which is about to ramp up.

Only one thing is certain; there are no coincidences in life or in the financial markets.

Editor’s Note: For market-thumping gains with mitigated risk, I suggest you consider the advice of our colleague Jim Pearce, chief investment strategist of Personal Finance.

Personal Finance, founded in 1974, is our flagship publication and it has helped investors build wealth for nearly 50 years.

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