Technical Analysis

In October 1981, following a period of strong inflation and dollar weakness, the yield on the ten-year U.S. Treasury note peaked at 15.84%. Since those daunting days, bond yields have gradually declined to the lowest levels in U.S. recorded history. To put the duration of this move in context, no investment professional under the age of 60 has worked in a true secular bond bear market.

During this long and durable decline in interest rates, there were periods were interest rates moved counter to the trend. In some cases, moves higher in yield were sudden and the effects on the economy and financial markets were meaningful. In my article “1987”, I showed how an increase of over 3.00% on the ten-year Treasury note over a ten month period was a leading cause of Black Monday, the largest one-day loss in U.S. stock market history.

Interestingly, historical short-term peaks in yield have been technically related. When graphed, the peaks and troughs can be neatly connected with a linear downward sloping channel, which has proven reliable support and resistance for yields.

The graphs below show the decline in yields and the respective channels for Two, Five and Ten-year Treasury notes. Our focus is on the resistance yield line, the upper line of the channels.

The composite graph below shows all three securities together with labeled boxes that correspond to commentary beneath the chart for each era.

Currently, all three Treasury note yields are perched up against their technical resistance lines. From this, we can conclude there are three likely scenarios.

1. Resistance holds and yields decline sharply as they have done in the past
2. Yields break above the trend line, marking the end to the 35-year-old bond bull market
3. Yields meander with no regard for the dependable technical guideposts that have worked so well in the past.

Bond Investors and holders of other financial assets should pay close attention to this dynamic and be prepared. The following summarizes expectations for the three scenarios listed above.

1. Resistance holds and yields decline sharply– If yields decline sharply as they have previously, it will likely be due to slowing economic activity and/or a flight to quality. A flight to quality, in which investors seek the safety of U.S. Treasuries, is typically the result of financial market volatility and/or a geopolitical situation. Given extreme equity valuations, investors should be prepared for significant stock price declines, as was witnessed three of the past four times the resistance level was reached and held.
2. Yields break through the trend line– If resistance does not contain yields, it is quite likely that technical traders will take the cue and accelerate bond selling and shorting, leading to the possibility of a sharper increase in yields. This condition could be further aggravated by poor supply and demand dynamics for Treasury securities as noted in Deficits Do Matter. Given the amount of economic and financial leverage outstanding as well as the economy’s dependence on low interest rates, we expect growth will suffer mightily if yields rise aggressively. In turn, this will dampen corporate earnings and ultimately weigh on stock prices.
3. Yields meander– This is the Goldilocks scenario for the economy and the financial markets. This scenario rests on a healthy equilibrium in the economy where growth is moderate, and inflation remains tame. Given that current interest rates are not high enough to significantly harm economic growth or hinder government borrowing, we suspect that the massive fiscal stimulus along with decent global growth will keep GDP propped up. We also suspect that, despite high valuations, stocks would likely be stable to higher.

 Related: Here’s How to Handle a High-Volatilty Market.