US Treasuries Soar……As Predicted

The S&P500 finished the week essentially unchanged, after dropping for six consecutive weeks.  Yet because prices fluctuated wildly during the week, volatility soared almost 16%, as measured by the VIX index.  Volume was also stronger.  This is a sign that the market’s melt-up complacency, that dominated for the last eight months, is coming to an end.  Investors are becoming more defensive and buying puts to protect against severe downside movements.

The macro data were not encouraging.  Producer and consumer prices rose more than expected (both headline and core), but if the economy continues to slow down dramatically, look for these inflation pressures to ease—just as they did in late 2008 and late 2010.  Retail sales rose less than expected.  The Empire State Manufacturing survey collapsed into negative territory, as did the Philly Fed survey.  Both were projected to rise!   Initial jobless claims were still solidly in the 400 thousand range.  While May housing starts were a bit stronger than expected, they’re still scraping near record lows (and were well below May 2010 levels).  Finally, consumer sentiment was much lower than the consensus forecast.

Technically, the S&P is still quite oversold, on a short-term basis.  It’s as if investors are looking for any reasonable excuse to bounce higher, at which time many take the opportunity to sell.  Only the most die hard bulls will continue to accumulate shares.  The S&P broke many important support levels, but for now, it did manage to bounce up from the 200 day moving average.  Over the next few weeks, after the much anticipated bounce (if it happens), the S&P will very likely retest the 200 day moving average.  Should it not hold, expect a much more severe sell off, perhaps taking  the S&P down below 1,200 for a consolidation phase.

Almost six months ago, this blog submitted an entry titled “US Treasuries on Sale?” where a case was made to BUY Treasuries—not so much for the current coupon, but for the strong probability of capital appreciation.

Here was the argument:

US Treasuries have suddenly become cheap.  The 10 year yielded as little as 2.33% in October.  Today, it offers 3.62%.  In the Treasury world, that’s a massive sell-off.

Also, it’s interesting to note what happened to Treasury prices the last time the Fed’s QE program wound down.  Back in April 2010, when QE1 officially ended, the 10 year Treasury began monster move up in prices (down in yield) that lasted six months.

The Fed’s current QE program is scheduled to wind down in a couple of months–after a huge price reduction in Treasuries has already begun.

If Treasury prices stop falling over the next 60 days, and risk assets start selling off (as QE2 winds down), then a repeat of the 2010 sequence would make a lot of sense, as investors rushed into a deep, liquid and relatively safe harbor to park cash for a few months.

What’s happened now….four and a half months later?

From 3.62%, the US 10 year yield touched 2.89% a couple of days ago. Depending on the exact security you bought (on the run, nearby or futures contract), your profit—had you bought them when they yielded 3.62%—would be about 6 percent, including accrued interest, or roughly a 16 percent return on an annualized basis.  In this same time frame, the S&P500 has fallen about 3 percent.

Not bad.

What’s most interesting is that this call in February flew in the face of conventional wisdom.  Bond gurus like Bill Gross, from PIMCO, were on every business news channel screaming that Treasury prices were about to plummet.

Wrong.

By the way, today is not the time to jump into the 10 year Treasury very aggressively.  While there could still be some more room for appreciation, the odds of further gains are not nearly as strong as they were back in February.

Sadly, the crowd will very likely not understand this, and will pile into Treasuries—in a few weeks or months, especially if we see a strong push down in the equity markets—right around the time when yields could be near their lows for this cycle.

Sometime after this last push down in yields, the smart money will be preparing to go……short.  So will we.

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