Whither Bonds? Sell ‘em hard! When?

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The Technical Trader’s view: There are a series of critical breaks which may fuel a bear market from these rarified levels: Watch for those critical breaks beneath 111-09, 109-20 and 104-00:

1. MONTHLY CONTINUATION CHART:This long term US T Note chart is notable for the repeated failure of the market to get above and stay above the 120 level...And the market has just failed twice recently.If the market were to break down through the two lows at 104 a good, solid, Double Top would have been completed.
2. WEEKLY CONTINUATION CHART:That recent double refusal is all the clearer here.In the medium-term the possibility arises of a Double Top if the market can get beneath 111-0.5.But we feel it should also break the two supports from prior Highs at 110-31 and 109-20.5 before sellers can be sure that the market is truly weak. Look closer still.
3. DAILY DEC 08 CHART:The double failure beneath 120 on the week chart becomes a four times failure at the 117-00 level in the day chart.Note too, the exciting bear possibilities that have now arisen: A push down through the possible Neckline at 111-09 would complete a clear and powerful Head and Shoulders Top. All this has yet to happen.But the bear potential found in the long medium and short-term charts is unmistakable. Watch for those critical breaks beneath 111-09, 109-20 and 104-00.

The Macro Trader’s view: Usually during times of economic weakness, or outright recession, as now, bonds are seen as a bull trade. That is because as an economy approaches recession, inflation usually falls, or is forecast to. And although government borrowing (through bond issuance) tends to rise as tax receipts fall, and benefit payments increase, this doesn't undermine the bull bond trade for a good while since it lags the overall trend in the economy. Of course, as the recession ends then bonds may eventually begin to fall as private demand for money competes with the public debt. But this time the situation looks very different. True, after a long period of relatively strong inflationary pressure, inflation is at last set to ease, as the leading economies all enter recession. But unlike in other post WW11 economic downturns, government borrowing is not just set to grow, it is exploding. In response to the near-collapse of the global financial system, the US, UK, Euro zone and others have pumped huge amounts of money into their Banks by way of state capital injection. Additionally, they have made billions available to guarantee inter-Bank lending in an attempt to get Banks lending to each other again and to the wider economy. Modern economies cannot function without a steady and readily available flow of credit. The drying up of this over the last 14 months is largely responsible for the now un-avoidable recession. These actions mean that governments will not only need to borrow to fund previous spending commitments once covered by tax receipts, but need to borrow even more to finance the financial system rescue plan recently adopted globally. This is the heart of the problem: the market won’t just need to absorb increased sovereign debt from one or two struggling countries, but from virtually every leading economy in the world, including the United States. In the US, the situation is made potentially even worse by the government nationalizing Fannie Mae and Freddie Mac which saw US Government liabilities soar by $5.4T, almost doubling the national debt. While this debt to a degree is self-financing so long as mortgagees continue to service their mortgage, the risk a large proportion will slip into default is very real, or else these two firms wouldn’t have needed to be rescued. In the UK Gordon Brown and Alistair Darling have said the previous fiscal rules will be ripped up and the UK will spend its way out of recession. While this guarantees a substantial deterioration of the fiscal position, it isn’t even clear that it will work, since greater government borrowing acts ultimately to crowd out the private sector, which ultimately is the true creator of wealth. So, faced with a near certain explosion of new government debt issuance globally, we judge long-term bond yields are set to rise substantially, in fact unraveling the last 15-20 years of falling bond yields, as many of the conditions that drove yields down during that period are either no longer in play or are reversed. Timing for a bear bond trade remains a matter of debate, but we sense once traders become accustomed to the reality of recession and fully aware of sovereign debt implications, bonds will sell off hard. Mark Sturdy John Lewis Seven Days Ahead

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