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Bond Spread More Evidence of Bottoming US Interest Rates?


Indexes reveal we may have reached an extreme.

On October 2nd, an excellent article by John Mousseau, portfolio manager at Cumberland Advisors, discussed the sharp sell-off in the municipal bond market over the previous several weeks. Mr. Mousseau attributed it to a number of factors, including a lack of liquidity on Wall Street, hedge-fund selling and bond-insurer downgrades, all of which resulted in the inversion of the spread between the yields on munis and on comparable Treasuries.

The chart in their report, which displayed the spread between the Bond Buyer 40 Index (an average of 40 long-term municipal bonds, compiled daily from quotations by five municipal bond brokers) and the yield of the 30-Year Treasury Bond, went back 3 years. My firm decided to go back further, to see if there was a longer term, discernible relationship between similar extremes in this spread and the future direction of long-term US interest rates.

To accomplish this, we spread the weekly Bond Buyer 20 Index (a narrower version of the Bond Buyer 40 that includes bonds rated A or better) against the 30-year constant maturity Treasury yield. We filled in the "missing data" between February 2002 and February 2006 for the Treasury yield, during which time the Treasury suspended the issuance of 30-year bonds, with data from the CBOE 30-Year T-Bond Index (which very closely tracks the cash yield) to produce a continuous data series.

Here's the chart:

The weekly yield since 1977, as indicated by the Bond Buyer 20 Index (blue line), and according to the constant maturity 30-year Treasury (green line), appear in the 2 lower panels, with the spread between the 2 yields (red line) in the upper panel.

The rightmost gray vertical highlight across all panels points out that the spread is at a 30-year narrow (actually inverted) extreme that, as Mr. Mousseau stated, indicates an extreme condition in the credit markets.

Although I didn't highlight every single instance for display purposes, the other vertical highlights point out that literally every similar (albeit less severe) extreme in this spread during past 30 years has always either coincided with or led an important bottom in long term US Treasury yields.
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