Close Correlation with Canucks
The correlation between the Canadian 10-year bond and US T-notes is strong. I mean, really strong. As a matter of fact, whenever someone gets busted trading US treasuries on inside information about a jobs report or something like that, you’d wonder why they didn’t just trade the Canadian bond instead of the T-note in order to stay off the radar.
By the way, I am not actually advocating this. If someone does this and gets caught, don’t blame me!
There are periods where the trends in these bonds can diverge for a bit, but it doesn’t seem to last more than a few months. So any diversion could be a setup for a mean-reversion trade.
There are also periods where one treasury will move faster than the other. If this pushes the spread to historically extreme levels, you have another potential opportunity for a reversal trade.
Way Up North
Don’t forget that treasuries prices trade inversely to the interest rates. So the global bull market in treasuries means we’re in a global bear market for interest rates.
The Canadian economy is weaker than the US. Therefore, their rates are lower, which means that their corresponding treasuries are higher.
In the cash market, the yield on the US 10-year note is at 1.57% while the yield on the Canadian 10-year bond is at 1.10%. That may not seem like a big deal, but the 42% percent premium on the US yield has pushed the Canadian 10-year bond futures contract to a full 16-point premium over the US T-note futures contract. This is a rich premium.
At the peak in 2006, the premium on the Canadian bonds was less than half of what it is today. When the 2006 high was surpassed two years ago, the spread between the two treasuries more than doubled over the next several months.
The only other time that the premium on Canadian bonds has been this fat or higher was for a few months either side of the Y2K (non-)event. By the end of the year 2000, Canadian 10-year bonds were trading at a discount to the US T-notes.
Suffice it to say, the current premium on the Canadian bond/T-note spread is at an historically high level. This could create a breeding ground for a major reversal.
In February 2015, the nearest-futures Canadian bond/T-note spread cleared the 16.50 mark. It peaked out at 16.90 less than a week later and reversed on a dime. The spread then plunged over six points over the next two and a half months.
In August 2015, the nearest-futures Canadian bond/T-note spread once again clipped the 16.50 mark. It peaked out just one day later and started a two-month decline. The drop ripped nearly four and a half points off the spread.
Just a week ago, the nearest-futures Canadian bond/T-note spread closed above the 16.00 level. This is not quite the 16.50 mark that told us to set the timer for the reversal the last two times, but it’s getting close. Based on the daily chart for the September spread, there’s a good reason to start monitoring the situation closely.
Will the Fib Stop Cause a Flip-Flop?
The September Canadian bond/T-note spread faces technical resistance at the Fibonacci .618 retracement of the entire decline from the January 15th contract high to the April 29th multi-month low. That Fib level is located at 15.97.
Last Wednesday, the September Canadian bond/T-note spread closed slightly above the Fib retracement for one day. It then backed off and has been sitting still for the last week. Traditionally, the Fibonacci .618 retracement is an ideal point to look for a secondary lower top to form before a market starts another leg down. If this happens in the spread, we’ll take a crack at the short side. If not, we will simply trail it higher with moving short sale parameters.
It’s also a point of interest that the spread closed about a third of a point below the Fibonacci .618 retracement last month and then endured a correction. The June 2nd high set price resistance that was surpassed on July 11th. The fact that the spread is now back below the early June top is indicative of a breakout failure, or what we like to call a Wash & Rinse sell signal. If prices continue to erode from here, a short sale could be warranted.
Place a hypothetical contingency order to sell one September Canadian 10-year bond contract and simultaneously buy one September T-note contract if the spread closes below 14.93 (premium Canada). If filled, liquidate the position on a two-consecutive day close .20 points above the rally high that precedes the entry (currently at 16.05).