Commitment of Traders (COT) data recently showed that speculators – a group that includes money managers and hedge funds – are record-level bearish on treasury bonds. This means a record-breaking number of treasury bond futures contracts were sold “short” in a bet that long-term bond prices would decline (and interest rates rise).
Betting on rising long-term interest rates is a popular speculation these days but we remain skeptical. On March 2nd we said: Wall Street Thinks T-Bond Prices Will Keep On Falling – We Disagree. Our disagreement with Wall Street was powered by multiple factors:
- The long-term down-trend for long-term interest rates is still intact;
- The “smart money” in treasury futures (the commercial interests) is record long (they’re on the other side of the trade from the speculators);
- Treasury bond prices had fallen to multi-year support;
- Our proprietary time cycle analysis suggests higher prices for treasury bonds.
Below you can see what happens when the “smart money” (commercial hedgers… not the speculators) gets record long in the treasury futures market. When the cumulative positions of commercial hedgers rises above the red line (in the bottom section of the chart) prices of treasuries tend to rise.
Prices of long-term bonds (like those tracked in TLT) have been on the rise for the past several weeks. While the recent gains in TLT are still moderate, we do think that TLT bears watching because of what strong buying in TLT could mean for the stock market as a whole.
Capital has recently flowed into safe haven treasury bonds on rising fears of a trade war, along with notable weakness in Dow components like Boeing (whose business could be hurt by a trade war).
When a “flight to safety” market movement occurs, capital tends to flow out of equities and into treasury bonds. If TLT surges from here, it would be a clear indication the same thing is happening again.
How much of a surge in TLT is too much? To answer that question, we did some digging into the data.
The measure we used, of course, was our own Volatility Quotient metric – the VQ. Specifically, we checked what happens to the S&P 500 when TLT moves up more than +1 VQ in a single month.
At the time of this writing, the VQ for TLT is 9.88%, so a +1 VQ move would imply an upward price surge of 9.88% or more. So, what happens when bond prices surge this strongly in a single month’s time? You can see the impact on the S&P 500 index in the results table below.
The basic conclusion is: When treasury bond prices surge, it’s a bad sign for equities… and the S&P has shown a tendency to decline by roughly double-digits when this happens.
Again, this is due to a “flight to safety” phenomenon. When capital is rushing into treasury bonds fast enough to make TLT surge, it is typically flowing out of risk assets just as fast… which means investors are likely nervous or concerned (or even panicked).
To be clear, this surge scenario is not playing out just yet. TLT has been up about 2% over the past week. TLT currently sits around $120. It would take a rise in TLT above $130 to constitute a +1 VQ move in TLT.
But even a modest amount of upward movement in TLT is something to keep an eye on… because conditions in general are so worrisome right now, and the possibility of a surge has a higher probability than normal. There are multiple reasons for investors to be nervous and pockets of weakness showing up in multiple areas of the market.
Given this high caution backdrop, we are watching closely for warning signs. Price action in TLT is one of those signs. If a sudden surge occurs, the major equity indices could go into correction very quickly.
Richard Smith, PhD
CEO & Founder, TradeStops