The Rate Rally Cometh

07/25/05 12:58:13 PM

by David Penn

Remember those lazy, hazy, crazy days of falling long-term interest rates?

Security: $TNX
Position: N/A

What makes a trend? For months this spring, financial observers seemed mesmerized by the phenomenon of falling long-term interest rates. Just about every financial argument--bullish or bearish, growth-oriented or recession-obsessed--made during those days seemed able to incorporate the falling long-term interest rate story into its own. Much of this befuddlement was chronicled in my Working Money article, "Bond. Lond Bond" (June 7, 2005).

Interestingly, a reader and trader in Europe emailed me a chart of the 10-year Treasury note a few weeks back. It wasn't the first time this correspondent had provided an eye-opening chart, so I was pretty curious to see what he was up to this time. The chart in Figure 1--a chart of the yield rather than the bond price--sums it up. And while that picture might have begot a thousand words, all that my colleague had to say were three numbers: 1-2-3.

As in "1-2-3 Trend Reversal."

Figure 1: A classic 1-2-3 trend reversal appears to end the dream of endlessly falling long-term interest rates.

Graphic provided by: Prophet Financial, Inc.

The 1-2-3 trend reversal is one of the gems in Victor Sperandeo's Methods of a Wall Street Master. At root, the 1-2-3 trend reversal is a one-step-at-a-time method for determining when a trend has, in fact, reversed. I've written about this pattern before, and do so again now both to remind traders and investors of this powerful technical set-up as well as to alert readers to where this powerful technical set-up is taking place. The latter point, of course, reflects very much the contemporary "conundrum" over long-term rates.

Here is how Sperandeo explains what he calls the "1-2-3 Rule" in his follow-up book, Principles of Professional Speculation:

1. The trendline must be broken--prices must cross the trendline drawn on the chart.

2. Prices must stop making higher highs in an uptrend, or lower lows in a downtrend ... This is often described as a "test" of the high or low point, and usually, but not always occurs when a trend is in the process of changing ...

3. Prices must go above a previous short-term minor rally high in a downtrend, or below a previous short-term minor sell-off low in an uptrend.

Writes Sperandeo, "At the point where all three of these events have occurred, there exists the equivalent of a Dow Theory confirmation of a change of trend."

Seeing these changes graphically on a chart is helpful. First we have a clear downtrend, as shown by the downtrend line in Figure 1 that connects the highest high of the relevant period (the first half of 2005), with the lowest high before the lowest low. This is elementary but key. Trendlines drawn in this fashion (also promoted by Sperandeo) have many advantages over other ways of drawing trendlines. But beyond accuracy--which is certainly vital--the consistency of this approach also makes it a superior way of casting trendlines, in my opinion.

The first step in the 1-2-3 Rule occurs as prices bounce in the first half of June, breaking decisively through the downtrend line. The second step in the 1-2-3 Rule comes in the second half of June, as prices attempt to make a lower low than that recorded earlier in the month. This is the test Sperandeo refers to.

The third step in the 1-2-3 Rule comes in mid-July, as the $TNX rallies above the "short-term minor rally high" of the first half of June. Another way I look at a successful completion of Step 3 is to see if the high (or low) point reached in Step 2--the attempt to set a lower low or higher high after the trendline break. Sometimes, there is no distinct "minor rally" in the downtrend to use, and the high (or low) of step two often suffices.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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