Magazine article Modern Trader

Could a Slide in Stocks Prompt a Short Squeeze in Bonds?

Magazine article Modern Trader

Could a Slide in Stocks Prompt a Short Squeeze in Bonds?

Article excerpt

The bear move in Treasury bond futures that started in October 1998 is 11 months old and has totalled more than 22 points. This makes it the second most severe bear move of the last 10 years after the 1993-94 period that lasted 14 months and totalled almost 27 points on rolling nearby futures series.

The adjoining T-bond chart uses the slow stochastics indicator on monthly data to help discern overbought and oversold conditions that often precede many longterm trend reversals. The average of the previous bear moves, starting from overvalued levels labeled in the chart, was a 16.3 point move lasting 8.75 months. The chart makes clear the oversold nature of the contract amid a slow stochastics reading rivaled only by the 1994 lows, suggesting that the market is in the final stages of the bear move now.

When the faster %K line crosses over the slower %D line and they both move above 25, a bull move will be signalled. If such a crossover occurs in the fourth quarter, traders should be quick to follow it. The fourth quarter is historically the friendliest time of the year for bonds. For example, 30year Treasury yields declined an average of 34 basis points in the quarter since 1984. During this time, they only rose more than 12 basis points once.

Meanwhile, the latest Commitment of Traders report shows the highest level of net short open interest in bond futures among large speculators since August 1987 at 57,438 contracts. The typical speculative trader uses a trend-following system, so when a market has been in a long trend, many different systems can recommend the same position -- in this case to be short bond futures.

As a result, a mild recovery in bond prices conceivably could be stretched into a short squeeze if these traders are forced to cover their positions. What could spark such a rally at a time when 30year Treasuries offer below average value by recent standards based on their current 3. …

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