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Using Price Channels To Confirm Price Reversals In The Bond Market

03/18/11 12:37:18 PM
by Billy Williams

Price channels reveal both trends and trading ranges but also powerful trend reversals such as what may be happening in the bond market, right now.

Security:   TLT
Position:   Buy

Interest rates, specifically the US bond market, is another possible opportunity as debt continues to hang around the US economy like an albatross. The US is fast approaching having its debt level equal to its Gross Domestic Product, and for most Americans, that will be the first time such an event has happened in their lifetimes. Hard measures have to be implemented eventually but, currently, it appears that the Federal Reserve will try to print its way out of the debt crisis, which will be a problem for most working people in the US, driving the price of commodities higher due to inflation.

For the bond market, in order to continue to attract foreign investors, the US government may have to offer higher interest rates on its bond auctions driving up the interest payments on an already shaky US economy. Short of that, foreign holders of US bonds may grow nervous at the current out-of-control spending in the country and the lack of resolve to get a real budget through Congress.

If this happens, bonds could plummet as investors try to recoup what they can before the bond market crashes completely. See Figure 1.

FIGURE 1: TLT. TLT, an ETF that shorts the US 20-year Treasury bond by 200% of its range, has been on a steady decline from its peak high, forming a downward price channel. However, in early February 2011, price traded up through its upper trendline, forming a higher high and higher low. Breaking through its new higher high, a new trend could be emerging as the bond market begins to falter.
Graphic provided by:
These uncertainties can keep you up at night but also prove that exchange traded fund (ETFs) like i-Shares Barclays 20+ Year Treasury Bond Fund (TLT) are worth considering to take a position in. TLT has been in a downward price channel but recently broken through its upper trendline while its price action has also been firming up near support, which could be ground zero for a new counter-bull trend to emerge as these strains in the system begin to grow.

Price channels are common price patterns that occur in trending stocks or stocks that are stuck in a trading range, but they offer strong signals as to when a countertrend has emerged. The upper and lower trendlines that form the price channel offer both support and resistance, but when price breaks through either of those trendlines, it reveals a possible shift in the trend that a skilled countertrend trader can capitalize on and exploit the beginning of a new trend.

Another fundamental reason for a possible trend reversal is the likelihood of a potential second banking crisis. After the banking crisis in 2008, a number of programs were implemented to make sure banks were solvent, which included the Federal Reserve lending money to banks at zero percent rates while also allowing banks to turn around and buy US Treasury bonds. This interest rate arbitrage on the part of the banks gave them the opportunity to pocket a safe return at an unheard-of overnight lending rate from the Federal Reserve.

The US government has also implemented programs to help prevent current homeowners who were struggling to maintain their house payments amid the country's recession by offering federal assistance and programs to allow those homeowners to restructure their original mortgages in such a way that allowed them to meet their obligations and remain in their homes.

However, many of these homeowners are struggling still, and with the real estate market left with no way to wash out bad home loans or foreclosures off their books, the real estate market still struggles to gain footing and banks left with cash but no prospects to get back into lending in a big way to make an impact in the country.

Worse, many of the toxic assets that banks had on their books and were responsible for the 2008 crisis are allowed to be written off the banks' books but were also allowed to not be reported by the bank itself. This measure was more of a Band-Aid enacted to prevent a run for the banks by the public, but the unfortunate consequence is that there are number of "zombie" banks out there and you have no idea of what effect these assets are having on the health of the bank or if it will cause them to eventually shut their doors one day.

While the uncertainties surround the current state of the US bond market, using a combination of technical skills and price patterns can help you spot new trends that are emerging and identify when the time is right to enter. But while these tools are powerful and the potential profits enormous, you must maintain a cool sense of detachment and patience in order to wait for these tools to confirm your next step and let the trade come to you instead of chasing it.

Billy Williams

Billy Williams has been trading the markets for 27 years, specializing in momentum trading with stocks and options.

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