US Treasuries… Update

The S&P500 slipped 0.2% last week on modest volume and declining volatility.  Once again, the most interesting action in the markets was in commodities, not stocks.  And the commodity markets are now suddenly much more volatile and look poised to turn south.  The US dollar, not coincidentally, had its two best back-to-back weeks all year.

The week’s economic news was mixed, but leaning to bearish.  The trade balance for April was worse than expected; this will put more downward pressure on GDP growth.  Retail sales missed slightly; excluding autos and gas, retail sales missed badly.  Producer prices were higher than expected.  Consumer prices just about met expectations.  Weekly jobless claims were again higher than predicted.  But consumer sentiment was slightly better.

Technically, the S&P is at a crossroads on the daily charts.  For the uptrend from the March lows to remain valid, the S&P must close higher next week.  If it doesn’t, then a potentially important turning point may be reached.   With all of the negative divergences building throughout 2011, the break—downward—could be especially severe.  The stock market appears to be very coiled, like a spring, and it could unwind very quickly if the appropriate catalysts hit it.

If a sell off in equities were to occur, then the US Treasury market will be a prime beneficiary.

But how have Treasuries done since we first recommended them back in February?

It turns out that only about a week after the February 5th post, Treasuries hit their lowest price of the year (so far) and have rallied—massively—since then.

Just as predicted.

But this is exactly the opposite of conventional wisdom and some big bond managers were predicting.  The common view was that Treasuries would start selling off badly (interest rates would start soaring) as the end of quantitative easing approached.  Yields, these so-called experts predicted, would spike well above 4.0% on the 10 year note, for example.

What happened instead?

The 10 year rate collapsed from over 3.6% to almost 3.1% as of Friday last week.  Over the last three months, this translates into (roughly) a 13% jump in the value of the note, excluding the accrued coupon, which adds almost another full percentage point of return.

14% return over three months.  Not bad.  Especially compared to the S&P500 which is essentially unchanged since mid February.

Where does this leave us now?

The best is yet to come.  The bulk of the bullish effect laid out in the February 5 post has yet to be fully expressed.  Since QE2 will be winding down in about a month, the big money movement into Treasuries hasn’t even occurred….yet.

Much of the current rally has happened because the folks who were betting against Treasuries—and losing—have begun to stop their losses.  This alone drives the price up further.

But when the big—long awaited—“risk off” phase commences, after the loss of QE2 liquidity slams the markets, a tsunami of scared money could rush into Treasuries.

The recent downturn in the commodity markets was the first sign that this (selling of one asset and movement into Treasuries) rotation may have begun.

But when the big selling begins—in stocks, in high yield corporate bonds, and in investment grade corporate bonds—the yield on the US 10 year Treasury could move down much further.

Depending on the severity of the sell off, it would not be surprising if the 10 year note fell to under 3.0%.  And if things get really ugly, the 10 year could dip to 2.5% or lower.

If, or when, that happens, we’ll discuss the next logical step: SHORTING the 10 year note.

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