Good Place For a Top
We live in a world of low or no yield in Treasuries. Many interest rates are even in negative territory! Nonetheless, when Treasuries or Treasury spreads reach prior tops or change their currently bullish price patterns, it could be worth taking an uber-contrarian position and going short.
I can’t count the amount of times that we’ve entered a spread long before it made any fundamental sense and then went on to make a huge profit. It seems that the fundamentals played catch-up weeks after we got in. By that time, the train had left the station and a big chunk of the move was already over.
The T-bond/T-note Spread
On the daily nearest-futures chart, the T-bond/T-note spread peaked at a high of 36-14 (premium T-bonds) last year…on April Fools’ Day! The top was established just a couple of weeks after the March 2015 contracts expired.
It is important to know what took place after the March 2015 contracts expired, because the June 2015 contracts were price at a significant 15-full point premium over the March contract. This was due to a change in the contract specs. The June 2015 contract is the first futures contract that reflects the period between 2001 and 2006 when the US government did not issue any 30-year bonds. Ergo, the huge price premium. So the mid-March surge was not nearly as spectacular as it looks.
Nonetheless, after the April price peak was established, the T-bond/T-note spread dropped nearly fourteen full points by the end of June.
Fast-forward to today. The global stock market sell off and ideas that the Fed will have to stop or even reverse their tightening monetary policy has propelled Treasuries higher for the last several weeks. So a week and a half ago, the spread traded to 36-10…just one-eighth of a point away from the 2015 April Fool’s top.
The T-bond/T-note spread then made a pullback into the middle of last week, followed by a rebound that erased two-thirds of the pullback. Is this a double top in the making? Maybe. The nice thing is that the pullback and initial rebound provides a great trade setup on the short side.
A break below the February 17th pullback low would mean that the T-bond/T-note spread has made a lower low after the bounce into (hopefully) a lower high. The resulting bearish price structure could mark the beginnings of a downtrend. It’s even more damning for the spread to have it happen after nearly tagging last year’s high. Therefore, traders would have a green light to get short.
The T-note/5-Year-note Spread
Moving closer in on the yield curve, the nearest-futures T-note/5-Year note spread soared to a three and a half year high of 10-07 (premium T-notes) on February 11th. It surpassed last year’s top and traded less than a point away from the 2012 all-time high. The T-note/5-Year note spread also pulled back in a February 17th low, but the bounce that followed was more muted.
The 2015 high in the T-note/5-Year note spread was 9-18.25. After surpassing it earlier this month, the nearest-futures spread pulled back below this old high and closed one-eighth of a point below it at 9-14. The spread is now back above the 2015 high. This puts it in a fluid situation:
A continued recovery that sends the T-note/5-Year note spread past the current high of 10-07.25 would be very bullish. It would indicate that the initial pullback and test of support worked.
Conversely, a break below the February 17th low would confirm that a Wash & Rinse sell signal has been triggered.
The Bottom Line
The run in the US Treasury spreads were followed by a brief pullback and then a bounce from last week’s correction lows. A break below last week’s correction lows could indicate that the run is over. If so, short positions would be the way to play it.
The blog will make a hypothetical trade by shorting one June T-bond contract and simultaneously buying one June T-note contract if the spread closes below 33-05 (premium T-bonds). Initially, the spread will be liquidated on a two-consecutive day close 8/32nds (one-quarter of a point) above the contract high (currently at 35-11).
The blog will make a hypothetical trade by shorting one June T-note contract and simultaneously buying one June 5-year note contract if the spread closes below 9-06 (premium T-notes). Initially, the spread will be liquidated on a two-consecutive day close 8/32nds (one-quarter of a point) above the contract high (currently at 9-30).
*Being in both spreads would be the equivalent of being short one 30-year bond and long one 5-year note. The long 10-year and the short 10-year cancel each other out. I am leaving the trade strategy as is for hypothetical purposes. But in ‘real life’ trading, you would want to pick one spread or the other to trade, not both at the same time.