US10Y: Higher Yields Here We Come

Bond prices tanked after the FOMC Minutes increased the likelihood of 2013 tapering event. Unlike Stocks and FX, Bond traders were unanimous in their reaction, with 10Y benchmark prices hitting lower without any significant pullback.

This is because yields have been artificially depressed since the introduction of QE1 in late 2008. Without QE purchases, it is unlikely that yields will be this low considering that alpha gains from Commodities and Stocks have been much higher in recent years thanks to cheap financing. To put it in perspective, US 10Y yields has been historically much higher, with an average of above 5% since 1962. Furthermore, any finance student would also know that the textbook risk free rate (e.g. pure cost of borrowing money without any other risk factor) is traditionally set at 3%, making the yields of the past few years look highly unnatural.

Stocks and FX traders may be forgiven if they are unable to determine what is the final outcome for their respective assets in a world without QE. However, in the case of yields, the answer is clear cut. Whether the US market is able to come out stronger without QE crutches is irrelevant in the context of yields. In theory, yields should decrease if the US economy starts to collapse again due to lack of stimulus, brought about by investors clearing stocks and pumping them into safer bonds.

However, it is unlikely that market demand will be able to make up for the decrease in Fed purchases. On the other hand, if the market managed to start running without crutches, the resulting optimism and renewed risk appetite would push yields higher as well.

We can simply look at historical pricing for guidance. From 1962 to 2008, 10Y yields have never fallen below 3.5% despite going through cycles of recession (depression even) and bull runs. The only time yields fell below 3.5% was in the era of QE. Hence, if everything reverts to normal (e.g. no QE), it is difficult to imagine yields going any other way but up.

Hourly Chart

That being said, volatility in the short run is still possible, which means that bond prices may still push up higher as part of your run-of-the-mill volatility reaction, rather than a directional play. Case in point, hourly charts show some slight pullback, with prices hitting the soft resistance around 124.65. Stochastic readings support the recovery, with readings seeking to form a bullish cycle signal.

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However, price may find this level hard to break as both fundamentals and short-term pressure remain on the bear side. Even if the 124.65 level is broken, there is sturdier resistance at 124.8, which happens to be the 38.2% Fib retracement (not shown on chart) of the post FOMC decline (from 125.5 high to 124.35 low). Considering that there have been various peaks around and under Stoch 50.0 levels, it will not be surprising to see Stoch bullish cycle (if one even formed to begin with) being cut short and pressure reverting back to the downside once again.

Daily Chart

The Daily Chart shows a breakout of a 125.0 round figure and the bearish rejection of the descending trendline. Currently, Stoch readings are also Oversold, suggesting that a corrective move higher is possible as well, in line with what the Hourly Chart tells us. Should 125.0 holds in the event of a pullback, the breakout will be confirmed and we should be able to see further bearish acceleration (e.g. higher yields) moving forward, agreeing with fundamentals. Even in the case of price breaking 125.0 and moving higher, the descending trendline will help to push prices lower, hence increasing the likelihood of a “fakeout” towards the upside.

Original post

Written By: Mingze Wu