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STOCHASTICS


Bonds Bounce Back

09/02/05 08:02:54 AM
by David Penn

A positive stochastic divergence following a 1-2-3 rule reversal sends bonds up and rates down in August.

Security:   TYU5
Position:   N/A

It's been a while since I heard the sort of bullish glee about this market that I heard yesterday afternoon from one of the market technicians I listen to regularly over the Internet. He has a "Macro Story" that involves a "massive bull market" in 2006, so perhaps his excitement over the possibility that the markets were doing with Hurricane Katrina in August what they did with the London terrorist bombings in July--namely, use them as a launching pad for a major improvement in investor mood and stock market returns.

Since I'm suffering from a Macro Story of my own (one that is admittedly different from that one), I can't fault the man when the markets seem to be adhering to his Plan. Nevertheless, because none of the technicals I follow have given me the sort of confidence to project madly bullish gains in the near future, I have to wonder just what this bullish technician is looking at.

Figure 1: After breaking down from a 1-2-3 trend reversal in July, September Treasury notes found a bid as a positive stochastic divergence developed between the July and August lows, sending bonds higher over the course of August.
Graphic provided by: Prophet Financial, Inc.
 
Well, one of the things on his screen was the bond market, which he insisted was screaming to the Federal Reserve, "Stop raising rates!" In the echo chamber that is the stock market (or is that just commentary about the stock market?), I can't help but wonder if that isn't the sound of anxious equity bulls rather than the sound of the bond market. So let's take a good look at exactly what the bond market is in fact saying through its price action since August.

The rally in bonds (with the accompanying decline in bond yields) in August came after a successful 1-2-3 trend reversal over the summer (Figure 1). I referred to this reversal pattern back in late July in an article for Traders.com Advantage ("The Rate Rally Cometh," July 25, 2005). To recap, the market broke down below its trendline in early June, rallied to attempt to set a new high in late June, then broke down below the, ahem, post-trendline-break lows in early July. From the point of the original trendline break, September 10-year notes fell from 113 to 110, a $3,000 per contract move in about a month.


But as the 10-year slipped lower toward 110, the stochastic oscillator was slowly but steadily creeping higher. This contrary movement--the falling bond price and the rising stochastic--created a positive stochastic divergence by mid-August, a divergence that signaled to bond market traders that the declines of the summer were likely coming to an end. And indeed they did. While the stock market was edging lower and lower over the course of August, 10-year notes rallied on the back of not only the positive stochastic divergence, but also a positive divergence in the moving average convergence/divergence (MACD) histogram as well.

What's next? As bonds move into September, there again appears to be a divergence between price action and the stochastic oscillator. This time, it is the oscillator that is moving lower while prices are moving higher. Should this pattern hold--more accurately, should the stochastic roll over and head back downward--then the potential for a top in the month-long August rally would be significant, particularly as the September Treasury note streaks toward a test of the June highs just north of 114.



David Penn

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

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