Bonds are reeling and as prices keep falling, yields continue to rise. The prospect of a sharp jump in market rates is not just important to bond traders; almost all investors are affected through mortgages or other loans, valuations in the equity markets or changes to asset allocation models.
The movement of interest rates is attracting increased attention. Since August 2005, the yield on the benchmark 10-year Treasury note has risen from 4% to a four-year high of 5.1%. The stock market and economy have remained resilient in the face of higher rates for the most part, but there is clearly a limit to how long that resiliency can last in the face of a relentless rise in yields.
By many indications, the sell off in the Treasury market has been overdone and conditions are now oversold. Oversold is a term used to define a security or market in which prices have fallen too far and are due to bounce higher. If this is the case, the recent period of interest rate angst might subside. However, experience tells us an oversold market can stay oversold.
Many indicators, especially some of the more widely used oscillators, can generate premature buy signals in these situations. Fortunately, sentiment analysis can help to identify true market bottoms. The idea of sentiment analysis rests on the notion that the investing public is generally right on the trend and wrong at both ends.
Treasuries entered a bear market in 2003. From mid June until early August, the 10-year note tumbled from 120 to 110. The swift decline started amid signs of economic strength. The sell-off gathered momentum in mid July when then Federal Reserve Chairman Alan Greenspan signaled in comments to the House Financial Services committee that the Fed was ready to begin raising rates. The decline in Treasures started one full year before the Fed actually started raising rates in June 2004.
Treasuries have never managed to break out of the funk that started three years ago. “Fall from grace” shows the slide. Despite rally attempts in early 2004, mid 2005 and in the fall 2005, a relatively obvious downtrend has developed in the 10 year. Prices have fallen back to levels not seen since July 2002 and the trend may have a ways to play out.
By some indications, the 10-year note is deeply oversold. Many charting programs provide indicators known as oscillators to help identify overbought and oversold conditions. Examples include stochastics, Bollinger bands and the Relative Strength Index (RSI). RSI is plotted on “Fall from grace.” During the recent decline in the 10 year, the index dipped below 30%, which hints at oversold conditions similar to those of March 2005.
Oscillators get their names because these indicators work well in up-and-down markets. When a security or market oscillates, it bounces higher or lower and fails to develop a definite trend. As seen in “Range bound” (right), Treasuries have been behaving in this manner. However, the oscillating has occurred as part of a downward-sloping trading channel. Any trader using RSI or other oscillators to identify potential rallies in Treasuries might have enjoyed short-term profits, but also longer-term disappointment.
Since mid-2003, there has been no reverse signal indicating prices have become overbought. RSI readings above 70% indicate overbought conditions. So, this oscillator has produced two buy signals during the past 18 months and no sell signals, despite a clearly bearish trend in the 10 year.
TURNING TO SENTIMENT
Understanding the crowd’s prevailing mood related to a security or a market can help traders better identify true turning points in price and avoid some of the false signals from other forms of technical analysis. Oscillators such as RSI are helpful, but certainly not stand-alone tools — especially not in markets that are trending strongly in one direction or the other.
Sentiment analysis, on the other hand, focuses on the long term trends and attempts to identify important turning points by understanding if emotion rather than logic is driving prices. It is also a way of identifying overbought and oversold conditions. But, rather than looking at a chart, sentiment analysis focuses on data. It can be applied to equities, commodities, futures or any other actively traded security.
The search for extreme levels of bullishness and optimism or bearishness and pessimism is an act of contrary thinking. It is based on the idea that if the majority of investors are bullish, they can’t all be correct. At that time the contrarian will turn bearish or cautious and look for a reversal to the downside.
When the crowd is too negative or bearish, chances are most have already sold and it is time to step in on the long side. For example, given the three-year slide in Treasury prices, the contrary-minded investor would want to see signs that bearish sentiment has reached an extreme and the investors have collectively “thrown in the towel” on Treasuries. So far that has not happened.
One tool for assessing market sentiment is the put-to-call ratio. Because put options often are used to hedge downside price movement or speculate on price declines, high levels of put activity generally accompany periods of rising levels of bearishness or anxiety. In other words, put volume relative to call volume tends to rise when investors and traders become anxious or nervous.
Put-to-call ratios can be used to quantify relative amounts of put and call volume. It is used in the equity markets for specific stocks and indexes as well as the futures market. Each day, the Chicago Board of Trade (CBOT) updates the total put and call volume for trading in the various futures contracts, including 10-year Treasuries.
To compute the put-to-call ratio, divide the day’s put volume by the day’s call volume. So, April 27, 2006 data shows 144,407 TY calls trading on the day and 226,073 puts. The ratio, then, is 226,073/144,407 = 1.57. Suggesting that approximately 1.5 puts traded for every 1 call, which is a typical reading.
Throughout time, traders want to see the ratio produce high readings to indicate that put activity is rising relative to calls. For that reason, computing averages makes sense. “Put it to them” (below) shows the 10-day put-to-call ratio for the 10 year so far in 2006.
Contrary to what would be expected, it has not been rising at all. In fact, even as Treasuries fell to their lowest levels of the year, so did the put-to-call ratio. So, the sentiment indicator is not consistent with extreme levels of bearishness or pessimism. In fact, it indicates just the opposite.
Another source of sentiment data is the Commitment of Traders (COT) report. Every Friday, the Commodity Futures Trading Commission releases the COT report for various commodities. The report includes the number of long and short positions held by large speculators, small speculators and commercial players.
The speculators are generally considered “dumb” money and when they are aggressively long or short a contract, it often pays to be trading against them.
With respect to the 10-year note, speculators have been adding to their net short positions. “In the market now” (below) shows the total long positions and short positions held by each week. From Jan. 3 to
April 25, the number of long positions increased from 629,942 to 859,321, which is 36%. At the same time, the number of short positions held by speculators rose from 673,430 to 1,036,113, which is 54%. Speculators have seen a dramatic increase in short positions in the 10 year so far from 2006, and from a contrary view this is a long term bullish condition. Fund flows is another sentiment indicator. The Rydex family of funds includes the most actively traded mutual funds among retail traders. The Rydex Inverse Government Long Bund fund (Ryjux), formerly called the Juno fund, is a bond fund that is designed to move in the opposite direction of Treasuries but with slightly more volatility. Each day, Rydex provides information regarding the amount of assets moving into and out of its funds. Watching the flows to the Ryjux fund is another way to track the investing public’s outlook for bonds.
So far this year, the fund has been losing assets despite declining bond prices, causing an increase in the fund’s net asset value, which is up 12.6% so far this year. “Kudos for Ryjux” (right) shows the decline in the fund’s assets. In short, the lack of interest in the in the face of the fund’s strong performance is a sign the recent decline in Treasuries has not rattled too many cages.
The trading activity in the iShares Long-term Bond Fund (TLT) also can be used to track sentiment relative to bonds. The TLT is an exchange-traded fund (ETF) and one of the most widely used tools for retail investors to bet on or hedge against the swings in long-term bonds. Its options also are traded actively, and applying the aforementioned put-to-call ratio to the fund can also shed light into relative levels of bearish and bullish sentiment towards the fund.
Recently, put activity has been relatively light and the ratio has been falling. The average 30-day median is only 0.68 and well below the levels seen earlier in the year. “Long-term flows,” below, shows the recent decline in the TLT put-to-call ratio. Again, the decline in put activity, relative to calls, has occurred during a period of falling bond prices. It indicates that any meaningful amount of bearish sentiment has not yet surfaced. From a contrarian view, the lack of pessimism or negativity is at odds with the notion that the Treasury market is now oversold.
WHEN IT WORKS
Sentiment analysis is not perfect. Price follows economics and fundamentals will have the greatest influence throughout the long term in any market, including Treasuries.
Technical indicators such as chart patterns and oscillators can help understand the speed and direction of a move. However, if these indicators consistently worked as stand-alone tools, there would more rich traders than there are currently. Today, the news and the charts are available to anyone with an Internet connection and it is very difficult to get an edge using the same tools that are available to the masses.
Contrary-minded investors can sometimes get an edge. At times, fear and greed drive financial markets rather than economics. Sentiment analysis can help identify these periods and help to pinpoint overbought or oversold conditions when many other technical indicators fail.
Regarding the recent downtrend in Treasuries, the sentiment data suggest we are not there quite yet. While the COT report has indeed shown a noticeable increase in bearish trades so far in 2006, other indicators don’t confirm its readings. The TY put-to-call ratio has been falling, indicating there has been no meaningful interest in put options even as prices are falling.
In addition, the action in the Rydex Fund and the TLT suggests most retail investors remain complacent with respect to rates. So, although prices have fallen to their worst levels in years, the sentiment data are not consistent with oversold levels, and it might therefore be dangerous to assume this particular trend has reached an end.
Frederic Ruffy is senior writer and trading strategist for options education firm Optionetics. E-mail him at firstname.lastname@example.org.