Is It Time To Buy Bonds?

05/12/06 02:53:10 PM

by Koos van der Merwe

The maxim is, "Buy when the blood is running in the streets." Should we follow it?

Security: N/A
Position: N/A

Let's face it: with the gradual rise in interest rates, blood has been running in the streets. "No one is buying bonds," one bond analyst shouted at me recently. " I am not making a decent living!"

So, when is it time to buy bonds? When will the US Federal Reserve stop increasing rates? The answer, of course, is when inflation stops rearing its ugly head. Milton Friedman, recipient of the 1976 Nobel Prize for economics, believes that the only way to control inflation is to reduce the amount of money printed. This effectively suggests that the way to fight deflation is to print more money.

In 2002, when the word "deflation" began appearing in the business news, Ben Bernanke, the current head of the Fed, gave a speech about deflation. In that speech, he mentioned that the government owns the physical means of creating money, implying that the government can always avoid deflation by simply printing more money. He referred to a statement made by Friedman about using a "helicopter drop" of money into the economy to fight deflation.

Since then, critics have referred to him as "Helicopter Ben" or to his "helicopter printing press." However, he was simply following Friedman's inflation/deflation strategy, so perhaps the nickname should more suitably be aimed at the originator as "Helicopter Milton."

What is more important, and something most seem to have forgotten, is the footnote to his speech. In it, Bernanke noted that "people know that inflation erodes the real value of the government's debt and, therefore, that it is in the interest of the government to create some inflation."

With US debt at alarming levels, why is Bernanke so adamant about increasing rates to fight inflation? Was the recent rate increase the last, in spite of the Fed suggesting that there may be another?

To answer this question, I decided to look at the i-Shares bond indexes. I kept my analysis simple, showing trendlines and the relative strength index (RSI).

Figure 1 shows the Lehman 1-3 Treasury Bond. I have shown (with arrows) how the RSI has been remarkably accurate in calling a turning point. I also suggested buy and sell levels based in interim trendlines. At the moment, the trend is still down, but the RSI is showing divergence to the i-Share. A move above the long-term resistance line A-C will confirm a major buy signal.

Figure 2 shows the Lehman 7-10 year bond is also suggesting an RSI buy. I would, however, wait for the i-Share to kiss the support line (A-C), which will probably show an RSI divergence when it does.

FIGURE 3: LEHMAN 20+YEAR TREASURY, DAILY. A buy signal is also suggested here. Is this a trend?

Graphic provided by: AdvancedGET.

Figure 3, the Lehman 20+year Treasury, is also suggesting a buy signal, and is more definite about it than the other two charts.

To conclude, the i-Shares Lehman bond charts are suggesting that the increase in US rates is close to, if not already, at an end. You could start preparing a list of bonds you would like to own, especially when the US market gradually moves into a major correction, as suggested by my article, "The Elusive B-Wave Of The S&P Index," posted on May 4, 2006, and you are looking for a home for your cash.

Koos van der Merwe

Has been a technical analyst since 1969, and has worked as a futures and options trader with First Financial Futures in Johannesburg, South Africa.