Yesterday we got the first US yield curve (3 and 5 year) inversion since 2007. Usually a recession follows within two years but I don’t want to scare you with that. Firstly, it doesn’t have to happen immediately and secondly, if you read any of my posts lately you know that getting defensive is not something we should fight against and in that case you’re well prepared for a case of a downturn.
The point of this post is to point out that we could see a flight to safety, that is into treasury bonds. A lot of people are expecting inflation and interest rates to rise over time, meaning bond prices to fall, including me (see Bond breakdown?). But it looks too many got ahead of themselves so it would be irresponsible to ignore the intermediate term risks in the market. Let me present what I think could happen.
In my opinion treasury bonds are forming a long term top that we’ll be talking about years from now. But this does not mean it must be a one way road lower. It is extremely hard to play tops and bottoms and this one could be no exception.
Before showing you a chart of bond prices let me start with a chart that shows how extreme the positioning of treasury notes is currently. In blue you can see an aggregated hedge fund positioning in 2-year, 5-year and 10-year T note futures.
It’s quite extremely short, isn’t it? So what if some of the funds that are short will be forced to start unwinding their positions? Meaning, they’ll need to buy just to close their shorts and here I’m not even considering establishing new longs. Can you imagine the buying pressure on prices?
If we take a peak at the chart of 20 Year T Bond EFT or TLT you’ll quickly get an idea what could go wrong.
TLT is currently retesting the breakdown level at $116. If this retest fails and the prices get above $116-117, then the unwind could start taking place very quickly and at minimal we should expect the price to go to $122 if not $128. If I translate this into treasury yields. US 10 year government yields fell under 3% recently and if they do not recover very quickly we could at least see a drop to 2.4-2.5%.