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Bound by Bears in Bonds



A lot of attention has been focused on the possible topping action in the bond market recently. The coverage now is similar to what was seen earlier this year after bond futures formed a short-term peak in March, as it seems a lot of traders are looking for a bounce so they can short some more bonds.

One of the ways to track investor sentiment in relation to the bond market is by analyzing the asset flows into and out of two of the bond funds that are offered by Rydex, both of which are chartered to track the long bond market, only in opposite directions. By observing how investors are moving their money between the fund that profits when bond prices RISE versus the fund that profits when bond prices FALL, we can determine whether sentiment towards the bond market is optimistic or pessimistic.

The following chart shows the bull ratio for the Rydex bond funds. The bull ratio is computed by taking the assets in the "long" bond fund and dividing it by the assets in the "long" and "short" bond funds combined. This gives us the percentage of total bond assets that are focused on the long side.

NOTE: Bond "price" in these examples is simply the yield subtracted from 100.

We can see that the bull ratio has just hit a new three-year low, as total bond assets are almost totally skewed to the short side (making the bet that bond prices will drop and bond yields will rise). We can also see that this bull ratio has shown a secular (long-term) decline over the past three years. This makes it difficult to know exactly what "extreme" may be. In order to correct for this, we can de-trend the data by looking at the current reading compared to other readings over the past three months. This ratio is below:

Currently, the bull ratio is 54% below its three-month average. So, even compared to recent activity, the current pessimism is quite extreme, and on a par with what was seen at the bond lows in October 2002 and March 2003. Green arrows are placed at those times when the bull ratio dropped more than 40% below its three-month average. This suggests that traders have jumped on the bandwagon, hoping to ride bond prices lower for the foreseeable future. From a contrarian point of view, that is bullish for bonds - meaning that when so many traders are focused on bonds declining in price, the opposite usually happens.

There are several caveats here, however. The assets in the Rydex bond funds are miniscule compared to the total bond market, so we cannot make the assumption that the sample size adequately reflects the entire population. Also, these funds can be skewed to a great degree by a single large trader if s/he decides to make a big bet one way or the other. Lastly, IF the bond market is finally topping out after all of the speculation that it would over the past few months, then these readings could potentially become much more extreme, and the possibility exists that "we ain't seen nothin' yet". Several of the other bond sentiment indicators I follow are not as extreme as these Rydex ratios and do not necessarily support a long trade in bonds just yet. But if this negative sentiment continues for much longer, then we should expect to see a bounce sooner rather than later.

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No positions in stocks mentioned.

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