The bond market is signaling that something big with huge implications for the future of the financial system is about to happen.

The prevailing view is that the Federal Reserve will deliver seven interest rate increases by 2023. Accordingly, bond yields have risen dramatically over the last few months.

And while this assessment may indeed be correct, given the current inflationary scenario, a little known indicator is suggesting that the bond market has come too far too soon and that a yield reversal is in the cards.

But before I detail this important phenomenon, it’s a good idea to review how bonds are structured and how the bond market works.

Bond Market Primer

Bonds are essentially publicly traded formalized loan arrangements between two parties. In the case of U.S. Treasury bonds, investors purchase bonds from the Treasury and receive interest rate payments throughout the life of the bond while receiving the return of their principle at the bond’s maturity.

Certainly, bonds can be confusing as they have two components, the price and the yield. These two parts work together to determine the bond’s value. When a bond is issued, it is offered at par value. But after issuance, the bond trades freely in the market and both the price and the yield will fluctuate depending on supply and demand and other applicable influences such as geopolitics, economic data, and of course inflationary expectations.

• Short-term bonds, 1 month, 2 month, 6 month and one year bonds, are known as bills.
• Intermediate-term bonds, generally 2, 5, and 10 year bonds, are known as notes.

Fixed Income Defined

Lets say I buy a $10,000 10-year U.S. Treasury note with a yield of 2% (TNX) at the initial bond auction (par value). In this case I would receive $200 in interest per year and the return of my $10,000 when the note matures.

Over time however, if after the bond or note is issued investors sell it in the open market, the yield will rise, for example to 2.3%. That’s because when the market price of the bond falls the yield rises.

On the other hand, if investors buy this note aggressively, then the yield could fall, maybe to 1.7%.

But that only refers to the yield as it changes from the time of purchase. The interest rate payment does not change.

So, no matter what happens in the open market, because the rate was locked in when I bought the bond, I can expect to receive $200 per year on this bond if I hold it to maturity. In addition, if someone else bought a similar note when the yield was 1.3%, that means that they paid a higher interest rate for the bond than I did. But they would still expect to receive an equal payment to mine.

As a result, because the interest rate payment amount is locked in, no matter what anyone pays for the bond, the income received is fixed if you hold the bond to maturity. And that’s why bonds are known as fixed income investments.

Thus, it follows that since most income investors are looking to hold the bond to maturity, when inflation rises above the interest rate of a bond’s yield, then many investors sell the bond because the interest rate received is not going to keep up with inflation.

Of course, if you buy a bond at price x today and it rises in price tomorrow, you can certainly sell the bond and pocket the profit from the trade. But that’s another topic altogether.

Where We Are Today

Now, let’s say you bought a U.S. Ten Year Note in March of 2021 with a yield of 1.52%. Since then, due to inflation fears, many have sold their bonds. Thus, the note is yielding above nearly 2.6% as of 4/6/22. That means that if you bought the bond in March, you’ve lost a great deal of purchasing power, even though you are still going to receive $152 per year for every $10,000 you invested.

Thus, you may want to hold that bond until maturity. But other investors clearly have not. And that’s why, as the chart below shows, bond yields have risen dramatically – because inflation fearful investors have sold their bond holdings aggressively, and yields have risen.

Let’s put this in perspective. In the current environment, you’re getting $152 (1.52%) per year in interest from a $10,000 investment while the Consumer Price Index (CPI) is growing at a 7.9% annual rate. That means that at the moment, you’re well under water in terms of inflation as it relates to this bond.

Getting Technical with Bollinger Bands

Now, let’s transition to what the bond market is telling us.

One of my favorite indicators is called Bollinger Bands (BB). In the bond chart below, they are pictured in red. There is an upper BB, and a lower BB. The black line in the middle is the 200-day moving average.

Bollinger bands were created by technical analyst John Bollinger and they are useful because they often signal when a price trend has gone too far or when a big move in any market is likely.

Usually, Bollinger bands are used in tandem with the 20-day moving average (MA) and one band is two standard deviations above while the other is two standard deviations below the MA.

Reliable Price Forecasters

When Bollinger Bands tighten around prices, they usually forecast a big move, although the direction is not always predictable. You can see this phenomenon prior to the huge bond yield decline in 2019-2020.

Furthermore, normal price trend behavior is such that when the price trend rises above the upper band it will return to the area inside the band and may return to the MA or the lower band over time. The inverse is true when prices fall below the lower band.

This is what is called a reversal to the mean. In other words, the MA and the two bands are like a magnet, known as an envelope. Prices can only move so far above or below the envelope before returning to the mean.

What The Charts Are Saying Now

So why do I think that bond yields could fall dramatically?

Because under normal circumstances the envelope is built around the 20-day MA. And that relationship works well for trading in time periods that last weeks to months. Moreover, the price moves related to this time frame are not usually considered long term predictors of the price trend.

However, by using the 200-day MA relationship to the Bollinger Bands you get a much longer term perspective of the trend for TNX, which is currently well outside the upper MA. Again, refer to the events in March 2020 when TNX fell well outside the lower band and delivered a long term trend reversal.

In other words, because we are at the other end of the Bollinger Band dynamic, we are now looking at a potentially significant long term move in bond yields in the opposite direction

In fact, what this chart is currently saying is that bond traders are betting that inflation will remain indefinitely uncontrolled, an equally extreme but diametrically opposite point of view compared to that of March 2020.

But what we know is that under normal circumstances, statistical behavior dictates that TNX has to return to the mean, the area inside the envelope. And that means that just as in the depths of the 2020 pandemic yields fell too far as investors feared we were on the verge of a depression, we are now at the opposite end of the fear spectrum, that of investors believing that we are on the cusp of uncontrollable inflation.

If the bands are right, as they were in March 2020 when they correctly forecast a major long term bottom in bond yields, we may be close to a meaningful top in bond yields.

On the other hand, if the return to the mean does not occur or is prolonged for much longer than it ordinarily would be, it would signal that the markets are now in a very abnormal place and that all preceding relationships have been abandoned.

If that’s the case, big problems will follow because the bond market will have been irreparably broken. Let’s hope the Bollinger Bands are not malfunctioning.

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