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Thursday, June 07, 2007 11:18 PM

Gold Breaks Down In Treasury Rout

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There was an absolute rout today in bonds, not just in the US but globally. Treasury trendlines are now clearly broken in several major countries. Following is a chart of the 30 year bond showing a distinct break in a trendline that dates all the way back to 1981.

click on chart for a much sharper image

For some unknown reason StockCharts has the decimal point in the wrong spot but otherwise the chart is accurate.

Brian McAuley at Sitka Pacific had this to say about treasuries in the May 2007 Sitka Pacific Client Letter.

In the 2006 Review I mentioned that the high in bond yields last summer presented a great buying opportunity, and we looked at a long-term chart of the 30 year Treasury bond yield showing the decline from the early 1980’s. At the time I was encouraged by the bounce off the upper end of the channel and the subsequent rally into the end of 2006 – it appeared another rally in bonds would eventually take yields down to another new low.

However, bond yields have now revisited the top of their channel, and it appears yields could potentially break higher and end their 25-year downtrends. If bond yields do break higher this year, we can expect the market to begin revaluing stocks in light of the new trend in interest rates; even if the level of interest rates themselves do not rise significantly at first, the market will likely begin to anticipate higher rates down the road, as it did in the late 1960’s and early 1970’s. This could completely change the character of the current decline in the market’s P/E from the 2000 peak, which has up to now benefited from lower long-term interest rates. Up to this point the market’s P/E has been able to come down even while the price of the market has remained buoyant, but that would likely change for the worse under a new trend of rising long-term interest rates.

In laying all this information and comparisons out over the past 2 months, in no way do I want to imply that we are heading for a direct repeat of the 1970’s experience. I only mean to suggest that some of the themes that played out during the last cycle of contracting valuations may play out again during this cycle: such as the continued decline of valuations given to stocks, and the outperformance of real assets vs. paper assets.

The potential breakout of Treasury bond yields and a new long-term trend of rising interest rates is certainly a key event that would heavily influence the market and economy in ways we haven’t seen in more than 30 years, and we are prepared for that shift if it happens.
Well the potential breakout in yields is now a fact. For the full text of the client letter click on the above link.

Also of note is a yield curve that had been inverted for almost a year has now gone pretty much flat except for the 3 month bill.

Note:$IRX is a discount not a true yield. The current 3 month yield is 4.79, not 4.66 as shown in the chart. Thus the curve is not as steep as it appears. Except for the 3 month yield, the curve is clustered from 4.96 to 5.24 which is a very significant steepening in just a couple months.

Kevin Depew was talking about Oh, THOSE Rising Interest Rates in today's Five Things.
This morning with the yield on the benchmark 10-year Treasury jumping well above 5%, the Financial Times helpfully pointed out that in the U.S. bond yields were rising because of "growing evidence of the resilience of the U.S. economy."
  • True, rising bond yields may to an extent reflect the re-pricing of interest rate expectations given the rate hike in New Zealand and the European Central Bank's hike on Wednesday, but there is also another not-so-small matter to consider.
  • We are conditioned to expect rates to move higher as the economy grows, a natural response to an increased demand for credit.
  • But what if interest rates were to actually increase as the economy slows?
  • Could that happen?
  • What if the predominant owners of U.S. debt - Asian Central Banks - were to find themselves with less money as a result of a slowing U.S. economy and consequently a consumer cutting back and purchasing fewer cheap (or not cheap, see yesterday's Five Things on Chinese labor) Chinese goods?
  • Absent a new buyer of U.S. debt, the net result would be a slowing economy with rising rates, would it not?
Around the Globe

Bennet Sedacca is talking about the rout in Government Bonds From Around the Globe

Charts and commentary cover Canada, Japan, Germany, and Spain. Arguably the most significant chart is that of Japanese bonds:

Note: The first two charts in this post were of yields. The charts by Sedacca are of bond prices (an inverse relationship).

Commentary from Sedacca

Get a load of the chart above of the last 22 years of action in Japanese bond futures. Now that's a big top building. Note that yields peaked/prices bottomed as the bubble in Japanese equities ended in 1989. That is one ugly chart. It surely seems that the correlation in markets isn't only in equities. It exists across the board. Same deal with credit spreads IMO. When they blow, it'll be a doozy. And this guy won't be near it.

That chart is indeed ugly as Sedacca suggests. The implication on the YEN carry trade should be obvious: If the market forces Japan to start hiking and the YEN rallies strongly in response, a massive unwind of the carry trade could be triggered.

Speaking on German Bunds, Sedacca said The 'coordination station' trade is really on. By the time he got to the rain in Spain it was "Let's just say that there may be (likely) a global bear market in bonds developing." Click on the previous link to see additional charts.

Asset Price Drubbing Following Good News

There was a pretty significant drubbing in almost all asset prices over the last few days. Was this unexpected? If asset prices were correlated on the way up, won't they correlate on the way down too?

The market had been rallying for months on end on bad news. I was waiting for some good news to see how the market would react. The Good News is that things are supposedly improving in the US economy. I don't believe that for one second but the market sure seemed to react to it. I wrote about this in Good News Everywhere!
Good news was flowing today.

Services growing at best pace in a year.
Gas prices fall 5 cents to $3.20 on average.
Capital spending revised higher in April.

The market has been rising on a tide of ever increasing bad news (led by housing, jobs, and a plunging GDP) for what seems like forever. I have been waiting to see how the market would react to a bout of good news. Today is our first test in quite a while. While it's far too early to draw in conclusions (we need to see the close and whether or not there is any follow through over the next few sessions), the preliminary results as of 11:30 AM Central aren't very pretty.

Perhaps the ultimate irony is that bull markets typically do not end on bad news. Bull markets end on good news, when the news is as good as it's going to get. Perhaps this is it, perhaps not, but it sure would be fitting if it was.
Gold and Silver Backtest

If you have to respect a treasury chart, then I guess you also have to respect a gold chart, a silver chart, a chart of utilities, homebuilders, reits, or whatever. There is always a chance of a headfake but right now one would have to say that there is also a chance that everything is going to unwind at once.

Gold Backtest
click on chart for a much sharper image

Silver Backtest
click on chart for a much sharper image

$655 appears critical for gold to hold if for the bullish case. But it looks like the miners could be in for a significant move down from here if gold and silver fail here (as looks probable).

The highs in bonds and the lows in yield have now likely been set. However that does not change my stance that once this unwind of leverage occurs, a recession sets in, and housing further collapses that the Fed will be cutting rates and yields will drop significantly. That is when I am looking for the next major rally in gold.

Seasonality for gold will look more favorable sometime late July or August and for traders perhaps better odds can be had a couple of months from now especially if this trendline break holds.

Mike Shedlock / Mish

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