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U.S. TREASURY BOND
TECHNICAL ANALYSIS
Prepared by Technical Data
A Division of Thomson Financial Networks
Even though the yield curve has flattened considerably over the past two years, the intermediate- to longer-term technical setup suggests that the curve will likely flatten further. On weekly charts, a well defined head and shoulders pattern has been in the making since early 1995. Last February, a solid break below this pattern's upward sloping neckline was a clear signal that a considerable amount of flattening was still in front of the market. The target of this head and shoulders formation currently comes in at the 15-basis point level. (The target line of this structure which parallels the upward sloping neckline is, however, also upward sloping. This means that the target objective will rise over time as well.)
Even more compelling is the observation that the weekly head and shoulders pattern could well be merely the “right” shoulder of a much larger head and shoulders formation found on monthly charts. Support derived from the neckline of this more ominous structure was broken at the 61-basis point level in August. A subsequent backside test of that same neckline held off an attempt to re-steepen a month later in September. The implication of this larger formation is that the yield curve will eventually invert over the course of the next couple of years or so. As of this writing, the target line of this larger head and shoulders points to a test of a hard-to-believe minus 250-basis points between Treasury 2-year notes and 30-year bonds. Similar to the weekly head and shoulders neckline, the monthly neckline also rises, but much more steeply. Consequently, the target objective will also rise relatively rapidly over time. Nevertheless, the technical viewpoint from each of these time frames is quite clear: the curve will likely flatten substantially more and could very well invert.
Why is this likely to occur? To begin with, it is clear that the Fed's bias remains on the side of tightening. On top of that, October's employment data came in on the high side of most street estimates and painted a picture of a tighter-than-expected labor market which, by itself, lends itself to monetary restraint. On the other hand, the Fed will likely be very reluctant to raise short-term interest rates because of the apparent fragility of domestic equity prices as well as the global equity markets.
In fact, some economists have suggested that a 10% to 15% correction in the Dow Jones Industrial Average and/or the S&P 500 Index could dampen consumer optimism enough to trim as much as 1/2% to 1% off of GDP. This could theoretically preclude the Fed from having to tighten to slow the economy down with monetary policy. For now, the Fed is on alert to fight inflation which should keep short-term rates relatively high.
That said, however, is that there does not appear to be much inflation at the consumer level. In fact, the devaluation of currencies in the Pacific rim area as well as in other parts of the world will likely cause deflationary pressures–particularly from cheap imports–for months or even years to come. This, along with the fact that the Fed is prepared to fight inflationary pressures if and when they develop, could dampen any inflationary expectations which would be a major plus for long-term bond yields.
In summary, the combination of full employment, the Fed's tightening bias, the absence of consumer inflation and the likelihood that cheap imports will be with us for a while appears to be a recipe for a flatter yield curve.
December, 1997Jim Donnelly, Chief Technical Analyst
Technical Data
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