Treasury and investment-grade bond funds have broken down to multi-year lows following the Federal Reserve's eighth rate hike since December 2015, dropping them into long-term bear markets. Rising yields will now compete with equities and other asset classes for investor capital, waving red flags for the stock market's multi-year uptrend. Rates may continue to rise into the new decade, making bonds even more attractive to the market's biggest players.
Legendary technical analyst Edson Gould summed up a classic rule describing the long-term relationship between stocks and bonds, commonly referred to as "three steps and a stumble," noting, "whenever the Federal Reserve raises either the federal funds target rate, margin requirements, or reserve requirements three consecutive times without a decline, the stock market is likely to suffer a substantial, perhaps serious, setback."
The Fed has already exceeded Gould's requirement by five hikes, but this economic cycle started from the deepest recession since the 1929 crash, giving central banks plenty of wiggle room before the stock-bond equation shifted away from equities. It looks like that day of reckoning has now come, raising the odds that price action since the start of 2018 will eventually metastasize into a long-term top. (See also: Intermarket Relationships: Following the Cycle.)
The iShares Barclays 20+ Year Treasury Bond Fund (TLT) offers a popular choice for traders and market timers seeking to play the bond market through equities. The fund came public in July 2002 and ground sideways in a narrow range pattern, ahead of a 2008 breakout triggered by the economic collapse. That buying impulse faded quickly, dropping the security to pre-crisis levels, ahead of a secondary uptick that posted a new high in 2012.
The fund and long-term Treasuries printed nominally higher highs in 2015 and 2016, adding to a rising trendline that has marked resistance for the last decade. Price action between 2014 and 2018 completed a head and shoulders variation known as a "faucet" pattern, breaking down this week on heavy volume. This selling wave targets $108 as an initial target, where rising channel and Fibonacci support should trigger a relief rally.
A channel breakdown would increase the likelihood of a more severe decline that coincides with the next major recessionary cycle. It could also signal the first long-term yield advance since the 1980s, when rates peaked above 14%. That would mark a crushing blow for equities, perhaps dropping them into multi-year bear markets. For that reason, it's wise to expect a ferocious defense of the $108 level by insiders who have the most to lose in an era of rising yields. (For more, see: Overview of the TLT ETF.)
The iShares Barclays Aggregate Bond Fund (AGG) holds the highest total assets in the group. This investment-grade fund entered an immediate uptrend after coming public in September 2003 and continued to gain ground into 2008, A steep slide got bought during the October crash, yielding a rapid recovery and new highs into 2012, when it topped out at $112.71. Two failed breakout attempts into 2016 completed a triple top pattern that broke support at the 2013 low this week, dropping the security into a bear market.
The 2009 and 2011 lows between $103 and $104 (red lines) may slow or stall downside momentum, allowing bulls to mount a brief recovery effort. That bounce may offer a low-risk short sale opportunity above $105 for market players willing to pay the monthly dividend, which currently yields 2.89%. A Fibonacci gird stretched across the 2008 into 2016 uptrend generates initial downside targets at $100 and $97. (See also: AGG: iShares Barclays Aggregate Bond ETF.)
The Bottom Line
Major bond funds broke down this week, dropping to multi-year lows while signaling the start of an adverse period for equities and other growth-dependent assets. (For additional reading, check out: The Economy Is Flashing Warning Signs to Investors.)
<Disclosure: The author held no positions in the aforementioned securities at the time of publication.>