Has the bond bubble burst?

A week, Harold Wilson once said, is a long time in politics. A month in financial markets? An eternity. It can even separate generational bull and bear markets.

Look at US sovereign bonds. In the middle of August, I highlighted the ‘melt up‘ in this corner of the market, and wrote that we could be seeing the ‘greatest bubble in a decade‘ (Aug 19).

While prices did rally further afterwards, these new highs were marginal. Note the 1-2-3 pivot highs pattern in the iShares 7-10 Year Bond (IEF) when it rallied from 112 to 114. Once this pattern emerges without a decisive upward climb, prices broke down because all buyers who wanted in have already bought into the instrument (see below).

For the longer maturity bond ETF – iShares Long Bond (TLT) – prices developed this 1-2-3 pivot highs patterns too before they retraced significantly this week (see Featured Chart).

So, has the bond bubble burst? It may be too early to say conclusively. Right now these instruments are just unwinding their accumulated overbought froth. Prices are merely reversing into their long run means. Even this reversion is enough to wipe out the price gains over the last four weeks.

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Throughout July and August, buyers were joining a crowded trade, ie, long sovereign bonds. In doing so, they took on huge price risk because these instruments were accelerating upwards and were vulnerable to corrections. Moreover, once the bull runs exhaust, prices alway drop faster than they climb. The last buyers are likely to be ‘trapped’ at the highs.

Now that these corrections have arrived, it could last further. But prices may well be volatile as the bulls and bears tussle to gain control.

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