August 31, 2009

US Treasury Futures and Interest Rates

Current price action in the weekly chart above demonstrates the relationship (from left to right) between Two, Five and Ten year US Treasuries against the landscape of a normal yield curve. Plotted in the price area of the chart are modified Bollinger Bands (set at 2.618 and a 20 period moving average) and an Ichimoku Cloud. In the indicator portion of the chart is a studied titled rSquared - a tool useful for indentifying trend.

In a normal yield curve, interest rates at the long end, represented by the Ten year US Treasuries, should be higher than those at the intermediate (Five year) and short term (Two year) maturities. The inverse relationship between bonds, represented by the US Treasury futures, and interest rates is holding true in the current market place as rates have fallen sharply during the past two year ascent in bonds.

Note that in June 2007, denoted by the first blue vertical line, US Treasuries had formed their base. In fact, the yield curve had just reverted from negative in May of that year when Two year yields actually dipped below Ten years for the first time since August of 2006. Several pundits and economists hailed this as evidence that an inverted yield curve did in fact not foretell recession.

Taken from the unemotional stance of a Technician, the yield curve did in fact spell trouble. With the FOMC holding steady at 5.25% in June 2007, the bottom was in and Treasuries foretold falling rates were ahead. The steep ascent in interest rates from their post 9/11 lows had abated, and the market began to stumble. This reversal was a key indicator of things to come - could the opposite be unfolding now?

Note that the reversal in June 2007 came with low readings in the rSquared indicator, indicating low trend levels. When the recent high in Five and Ten year Treasuries was set in December 2008, trend readings in all three maturities were very high. Since then, we've seen Two years inching up, Five years trending sideways to down, and Ten years falling. The upper level of the modified Bollinger Bands has gone largely unchallenged, and trend readings in the Ten years are picking up.

Whether or not interest rates will remain low for the foreseeable future is open to debate. Though inflation has appeared to have been held at bay, there are signs coming from the commodity market that threaten to undermine the Fed's current stance. Talk is rampant regarding how and when the Fed will unwind its work of recent months, all but signaling their accomodative policy will taper off. For the moment, the table has been set. With longer maturities out yielding shorter tenures, there is room for higher rates amongst the landscape of a normal yield curve.

Technicians should look for reversals in the short-term maturities as follow through on a possible bottoming in rates, and look for trend readings to once again pick up. A break below the Ichimoku Cloud, and the ability of all three maturities to assault the lower levels of the modified Bollinger Bands, will give clues as to interest rates going forward.

Jeffery E. Lay, CMT
President
Talon Eight, LLC

Disclaimer: This post is intended solely to disseminate information, and is not, and shall not be construed to constitute financial, investment or other similar advice. All posted material should be independently verified for accuracy and current applicability. Readers of this post are referred to the Risk Disclosure for further information.

[Return to Analysis]