Treasury Tumult
Fundamentals
Bond futures are slightly higher this morning, but are eyeing their second losing week in a row due to improved economic data. Resulting strength in equities has hurt the Bond market on two fronts. The stability of stock prices has resulted in lower demand for treasury products to hedge risk. Secondly, the greenback tends to move inversely with equity prices and the lower value of the currency makes government debt less attractive to overseas investors. It is interesting to note that the PPI indicator came in significantly higher than expected, giving evidence that inflation concerns may soon rise to the forefront of investor concerns in coming weeks and months, which can be seen as a negative force for Bonds. CPI data came in pretty much in line with expectations, but it may only be a matter of time before rising costs are passed on to the consumer -- especially if economic data strengthens. Inflationary pressure has made precious metals a much more attractive investment for risk-averse traders.
While the previously mentioned factors are negatives for treasury prices, it's not all doom and gloom for Bond traders. The equity markets have continued to rally from lows made in the first quarter of the year without a meaningful correction, which suggests that prices appear to be due for a correction. The million dollar question is when and how much the market will correct. The PPI data is negative for treasuries in the near-term, but this can be a catch-22 for companies. If companies are going to absorb these higher costs to stimulate consumer spending, profit margins are going to be thin. If they pass the costs onto consumers, spending may continue to flounder. Fundamentals seem to support a bearish view for Bonds, but further price advances are certainly not out of the question.
Trading Ideas
The fundamentals and technicals do not give a strong bias one way or the other for Bond prices, so traders may wish to enter into a neutral breakout strategy. One such strategy would be buying a long strangle. Some traders may wish to purchase the November Bond 122 call (USX9122C) and the November 117 put (USX9117P) for a combined price of 2-10, or $2,156.25. Given the high cost of the trade, it may be appropriate for some traders to consider exiting the call position if the price of the December Bond contract closes below 117-16, while letting the put position run. Conversely, some traders may alternatively wish to exit the put on a close above 121-05 and let the call position run.
Technicals
The December Bond chart shows the market forming a triangle/wedge formation. The market can break out either way from such a formation, but the pattern does have an upward bias, as the trend preceding the formation is up. If the market does break out to the downside, the 117-16 area would be a support area. If this support is broken, the market may see significant downside pressure. The oscillators are neutral at the moment, with the momentum indicator showing very slight bearish divergence from the RSI.
Rob Kurzatkowski, Senior Commodity Analyst
