Ever since June of last year when Chairman Bernanke told congress of the likelihood that the FED would begin scaling back bond purchases (and thereby ending the support for low bond yields) the bond market has been in a tailspin. Any student of the markets know they can overreact to news and overreact to this news they did. The chart below of the 30-year Treasury bond shows the magnitude of the decline, 17% in 3 ½ months which is a HUGE move for bonds. The market mouthpieces were calling for the end of the bond market as we knew it. If this were football the refs would call a penalty for piling on.
What exacerbated the selloff was, as you can see in the 30 year bond price chart below, bond prices created a divergent high (1) (higher prices but lower momentum – identified in blue line in upper RSI pane) which was a warning flag even before Mr. Bernake said word one. Bonds were headed down anyway and Mr. Bernanke’s comments gave them a big shove.
What we know is that when the sentiment is overcrowded to extremes the best short-term move can quite often be in the opposite direction. Bond prices eventually bottomed in August (2) and spent the next 5 months building a base and chopping sideways. This basing pattern is something a technician looks for as if it actually is a bottom, it can present a very attractive entry point and profitable opportunity. As you can see late January bonds eventually popped their head up above the blue horizontal resistance (basing pattern) line but soon thereafter fell back down. This created a higher high (3) which, in addition to the higher low that printed in February (4), was the confirmation an investor should look for to let them know the short term trend has changed. There are no guarantees but this type of setup increases an investor’s probability of a profitable investment. Because I am working with other people’s money I prefer to add one more level of confidence before I commit to an investment which for me was for price to make a higher high. That high at (3) was tested 2 more times which proved its importance and finally broke through this week (5). This was the confirmation I needed. These patterns are nice as they provide estimated price targets and this has one that ends at about 115.5 (6). If this plays out the investment will conservatively provide a 5% capital gain in addition to the 3.5% yield this bond carries. While this would be considered a “yawner” if you are talking about risk assets such as stocks, for a bond this provides more than what you would expect from a bond in an entire year. While what I have is provided a conservative price target there is the possibility of even greater upside. If the stock market takes a long overdue breather there is no question some of the money coming out of stocks will find a temporary home in bonds and could be the catalyst to even higher prices.
With any investment It’s important to keep your expectations in check and the same is required here. This will most likely not be a straight line to 15.5 but rather a choppy ride. I have no question there will be a few times it will challenge our conviction. If I take the FED at their word and their promise to eventually raise rates but not until late 2015 or early 2016, I go into this investment managing as an intermediate term investment only (not buy and hold forever). But until then or until the market tells me otherwise, I find this contrarian side of the boat a compelling, low-risk to reward opportunity.