Time to bet against the house

The monthly closing 30-year yield chart above shows three major yield cycles of the 20th century that correspond with the 21-year 1920-1941 bond bull market, the 1941-1981 bond bear market and the ongoing, 27-year to date bond bull market. Since 2003 yields (and thus bond prices) have been mostly sideways as they have reached the upper end of a potential support zone -- illustrated between the dashed lines at approximately 4.26% and 3.20% -- that we have derived from yield behavior in the previous two cycles . The low to date of the current cycle was the June 2005 close at 4.219% while the January 2008 closing value was 4.354%.

We were in the vanguard of the bond bulls. In the 1980s before the then 8% coupon 20-year Chicago Board of Trade (CBT) treasury bond futures ever saw par our long term expectations were for that bond to trade well above the round number. Former E.F. Hutton commodity brokers and subsequently Shearson Lehman financial consultants, if they are still in the business, would tell you that our upside targets ranged from the mid-130s into the mid-150s. Well, the CBT 20-year 8% coupon bond contract specifications were replaced by the 30-year 6% coupon which caused a downward revision in the CBT bond's historic price series. Adjusted for that revision, the CBT 30-year bond price historic high at 124-12 in June 2003 would translate to approximately 142, thus falling into our old target zone. Just because a market attains targets does not necessarily justify expectations of a trend exhaustion. However, target attainment plus other market behavior that is suggestive of trend deterioration may raise the warning flag about potential trend reversal. Whereas the prevailing trend in long bond prices is up, broad sideways swings for four and a half years, recent technical price action, and current crowd psychology in the financial arena suggest that the long term trend may be reaching a terminal point. We will explore that prospect below.

Our first observation is that the United States government has had the best of all possible worlds since the 1981 cyclical peak in yields: for 27 years the U.S. Treasury, the "House", has been able to borrow money at progressively lower rates to finance an ever increasing budget deficit. Since about mid-2007 because of various problems with the credit worthiness of mortgage backed securities, institutions have plowed huge sums into safe haven U.S. government instruments. That herd behavior across the full spectrum from 30-day T bills to 30-year bonds is irrespective of yield differentials. For example, Bloomberg.com shows that a 3-month T bill yields 2.09%, the same as a 2-year T note, versus a little more than double that for a 30-year bond (4.32%). Those differentials suggest to us that broad market action is being motivated more by feelings of duress than by cool economic analysis. We often associate significant market turning points with financial duress and are alert in such an environment for what we consider capitulation behavior - usually when a player, individual or institutional, appears forced by circumstances to act out of desperation against his best interests. Have we passed that point? Given the plethora of ongoing negative announcements by financial institutions and their partial sellouts to foreign investors, probably not. One more big negative earth shaker may be waiting in the wings. But certain market action suggests that may not be the case.

The CBOE 30-year yield daily chart below features a development that may be symptomatic of downtrend exhaustion. On January 23, 2008 the daily range plumbed new lows (not to be confused with the monthly closing chart) for the ongoing down cycle. Noted on the chart, the daily range featured an unfilled down gap. The next trading day, yields opened higher and left another unfilled gap. This setup typifies a potential one day island. That would signify a reversal and complete retracement of at least the current down leg that dates from June 2007 (the high point on this chart near 5.40%). Concurrent with the island action, the daily stochastic indicator turned up to confirm a bullish divergence (boxed on the indicator). Not illustrated, the weekly stochastic indicator turned up on February 1, 2008 to confirm a bullish divergence on that indicator versus a price low last November. These developments may be the prelude to a large rally in yields (sell off in treasury bonds). The unfortunate fact about island reversals is that they are only confirmed long after the fact when observers are able to conclude that values never returned to fill the gap area.

Longer term wave structure, illustrated in the monthly continuation Treasury bond futures chart below gives us further reason to consider that the overriding downtrend in yields/underlying uptrend in bond prices is in its terminal stages. Admittedly we have labored for many years to make a coherent wave interpretation of the ongoing long term bond bull market. Illustrated below is what we consider a best case scenario where price swings since the 1981 cyclical low are tracing out a countertrend Elliott wave inverted flat. The yield lows of the 1940s (1.98% monthly close in July and October 1941) , which have not yet been violated, were the lowest yields seen since at least 1798 (Refer to A History of Interest Rates, Homer and Sylla, 1991). Those levels may well be the ultimate low in a secular bond bull market. In that case, the 1941 - 1981 rise in yields would represent the first stage of a secular bond bear market. Consequently activity since 1981 can be considered corrective, or countertrend.

In that context, we present the following interpretation of price swings that have transpired since 1981. Note that all of the swings consist of 3 subswings and they all overlap to some degree the preceding swing. Those conditions fit the definition of a corrective, countertrend phase. Comprised of 3 major swings (annotated A-B-C in boxes), the overall pattern subdivides as follows: Wave A is a 3-swing, a-b-c, move; Wave B is also a 3-swing move; and Wave C is a 5-swing move, i - v, where the fourth swing features further subdivision and comprises a classic wave 4 triangle (swings a-b-c-d-e, that are also considered a "3" in wave analysis). In this interpretation the ongoing advance from point C iv is the terminal fifth subswing in Wave C and its high will also mark the completion of the entire A-B-C pattern from the 1981 low.

Where could the upper extreme of this overall 27-year pattern be? By the rules of wave analysis, since swing C iii (124-12 minus 89-00 = 35-12) is shorter than Swing C i (101-03 minus 63-00 = 38-03), Swing C v cannot cover more distance than that of Swing C iii. Therefore, the maximum high for Swing C v is 140-11 (35-12 added to the June 2007 low of Swing C iv at 104-31). So the end of the overall pattern, C v, could terminate anywhere between point C iv at 104-31 and 140-11. If it terminates below the June 2003 high of swing C iii at 124-12, then a wave C v "failure" would exist. In our opinion "failures" in wave analysis, particularly at major trend extremes, are rare and tend to be anomalous. However, price activity illustrated in the weekly Treasury bond futures chart below indicates potential for just such a failure.

Trading since the June 2007 low has traced out a potential 5-swing advance as annotated on the chart above. Swing-1 covered 9-24 points, swing-3 covered 9-15 points and swing-5 covered 9-15 points. Because swing-5 was equal to or less than swing-3 the rules of wave relationships held and they suggest that this entire move is a completed sequence. Corroborating that is the behavior of the weekly 14-period stochastic indicator that turned down on February 1 to confirm a bearish divergence (see arrow on indicator). Because swing-4 falls back (overlaps) below the top of swing-1 the sequence may be interpreted as an overall a-b-c. That would maintain the consistency of the structure that we noted on page 3 where all of the swings consist of three subswings. That in turn raises the possibility that this illustrated up leg is the terminal swing v? within Swing C that is shown on the page 3 monthly chart. Implicit in the wave relationships noted directly above is that this potential swing-5 comprises a failure in the terminal Swing C within the overall advance from the 1981 low to date.

That's pretty heady stuff to consider. Intuitively, we would expect the ongoing escalation in the global credit crisis to bring about more bad news that would push U.S. interest rates lower. If the developments shown here in both the short term daily yield chart and the weekly treasury bond chart comprise terminal trend behavior, then volatile price action could develop in the near term as various players who are committed to expectations of lower long term interest rates are forced to reconsider their positions.

In summary, the high level consolidation pattern that has contained CBT treasury bond prices since June 2003 may well be the springboard from which prices leap toward a probable end of cycle high somewhere between the 124-12 high to date and 140-11, which we believe is the theoretical high of the cycle. At this stage, because of marketplace psychological factors and various technical aspects, we are observers awaiting outright market action that would be an early indicator that the treasury bond market's technical behavior discussed in this report is beginning to play out in favor of a top in the ongoing bond bull market cycle. For our money, the initial indication of long term trend exhaustion would be spot month CBT futures trading below 117-27 on a weekly closing basis. That level marked the low of what we call a weekly spike range where prices settle well above their lows - thus indicating strong underlying short term buying power. Since the weekly close of that range (February 1, 2008) was above 77% of the entire week's range, a violation of its it low at 117-27 (line A on the above chart) would indicate that short term selling pressure was dominating short term buying power. However, for us to feel more confident that a reversal of the entire 1981 - 2008 wave structure is starting to unfold, we would require spot month futures to trade below the weekly bottom reversal-type range of December 28, 2007 at 113-13 (point 4 on the above chart).

The below monthly Treasury Bond chart and momentum indicator are provided for perspective; no commentary is associated.

Footnotes:

1. We have never considered the marketplace to be a casino despite this use of the colorful phrase, "bet against the house".
   
2. Various sources including Knight Ridder, Reuters, CSI Data
   
3. Values since 1993 reflect the Chicago Board Options Exchange index.
   

Copyright ©2008 Eidetic Research, All Rights Reserved

Charts constructed with Omega Research SuperCharts and Equis MetaStock Data Source: Commodity Systems Inc.

This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any commodity, futures contract, or option contract. Although the statements of facts in this report have been obtained from and are based upon sources that are believed to be reliable, we do not guarantee their accuracy and any such information may be incomplete or condensed. We do not assume responsibility for typographical or clerical errors in this report. All opinions included in this report are as of the date of this report and are subject to change without notice. Employees of Eidetic Research may hold positions in futures or cash markets that are either in accordance with, or contrary to, stated conclusions within this report.

Eidetic Research

Information contained herein is obtained from sources believed to be reliable, but its accuracy cannot be guaranteed. It is not intended to constitute individual investment advice and is not designed to meet your personal financial situation. The opinions expressed herein are those of the author and are subject to change without notice. The information herein may become outdated and there is no obligation to update any such information. The author, 24hGold, entities in which they have an interest, family and associates may from time to time have positions in the securities or commodities discussed. No part of this publication can be reproduced without the written consent of the author.