Don’t Call a Top in TLT — But Be Prepared

by LearnBonds.com | August 6, 2012 6:30 am

With interest rates making record lows on a monthly (if not weekly) basis, many people are talking about a bubble in the price of bonds. (Bond prices move in the opposite direction of interest rates.) This type of talk often gets traders excited, as everyone wants to be the person who not only called the top in the market, but made a lot of money when the trend reversed.

Of course, this is contrary to the advice of many top traders to “trade with the trend,” but we know many traders will try to call the top.

BondChart1 300x180 Don't Call a Top in TLT    But Be Prepared
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While I think we have at least another year or two left before bond prices move lower, something on the charts has caught my attention.

If you follow the chart of the iShares Barclays 20+ Year Treasury Bond Fund (NYSE:TLT[1]) — the popular bond ETF[2] that tracks the price movement of 20-year Treasury bonds — you likely remember the long battle it had with the $124 price level. As you can see from the daily chart, that battle took place over the final months of 2011 and lasted all the way into April 2012, when the bond bulls finally overcame the bears to seize the day.

The technical signs appear to be decisively bullish:

BondChart2 300x181 Don't Call a Top in TLT    But Be Prepared
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However, if you look closely, a pattern might be forming that could be … not so bullish.

For those of you who are familiar with technical analysis, you can see we recently have formed the start of a head-and-shoulders top pattern. You can see on the chart what could turn out to be the left shoulder and head. (Those of you who are not familiar with this pattern can learn more about it here[3].)

As Sam Collins talks about in his article, it can be dangerous to jump the gun with a trade before the five conditions he lists have been met. In this case, the right shoulder has not formed yet, so the pattern is far from completed. However, if we are seeking to protect a long position, it would be dangerous not to keep an eye on the potential pattern that might be forming, or what a break through the $124 support level would mean — even if the pattern does not complete.

For those itching to initiate a new short position and call the top of the Treasury, this level should be watched as well. While you will not get the exact “I called the top” bragging rights, your pocketbook likely will be much heavier if you wait for a confirmation that the trend has reversed before putting your money on the line.

It’s hard to turn on the financial news without hearing someone say the short treasury trade is one of the following:

In fact, the following statements were all made by one of the bond market’s permabears, Doug Kass, over the course of two years. And he has been wrong, very wrong[4]. So far, you have not missed anything by not listening to the bond bears.

Why Is TLT a Popular Way to Play Rising Interest Rates?

TLT is fund with a long duration. The longer the duration[5] of a fund or ETF, the more reactive the fund will be to changes in interest rates. The duration of TLT is about 17 to 18 years. Basically, a 1% move in interest rates will trigger a 17% move in the price of TLT.

While TLT is not a leveraged ETF, several funds offer the ability to effectively double down on your trade — however, we recommend not using a leveraged ETF in this case[6].

Visit learnbonds.com for more on bond investing strategies and education. Email questions to info@learnbonds.com.

Endnotes:
  1. TLT: http://studio-5.financialcontent.com/investplace/quote?Symbol=TLT
  2. popular bond ETF: http://www.learnbonds.com/largest-bond-etfs/
  3. learn more about it here: http://investorplace.com/2010/02/identifying-a-head-and-shoulders-chart-pattern/
  4. And he has been wrong, very wrong: http://www.learnbonds.com/doug-kass-short-treasuries-call/
  5. duration: http://www.learnbonds.com/bond-duration/
  6. not using a leveraged ETF in this case: http://www.learnbonds.com/using-etfs-to-short-the-treasury-market/

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