Brocker.Org: Bond Funds Heat Up in Cooling Market

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Bond funds turned sharply higher ahead of Wednesday’s Federal Reserve decision to raise interest rates and closed strongly, despite the news. This contrary behavior signals disagreement about inflation and its impact on borrowing costs in the second half of 2017 and beyond. In turn, the rally could presage a major Fed policy error, aggravated by follow-up commentary that foresees an aggressive hike schedule into 2018.

U.S. growth in the first half of 2017 has missed optimistic projections, while forecasts for strengthening in the second half have drawn growing skepticism. While the Fed is determined to normalize policies following its unprecedented quantitative easing programs, the U.S. economy may not cooperate in the eighth year of an economic expansion, despite promises of tax cuts and other business-friendly initiatives by the Trump administration. (See also: How Will the Fed Reduce Its Balance Sheet?)

The iShares 20-Year Treasury Bond ETF (TLT) spiked to $123 at the tail end of the 2008 economic collapse and settled at support in the upper $80s at the start of the new decade. It posted nominally higher highs in 2012, 2015 and 2016, linking a rising trendline that now places resistance near $147. The fund sold off in a vertical slide following the presidential election, with popular opinion expecting a rapid escalation in U.S. growth in line with Republican campaign promises.

Weaker-than-expected first quarter GDP and an Oval Office under siege have slowed or stalled expected initiatives that include tax cuts and regulatory relief, raising doubts about the growth trajectory in coming years. In turn, this has reignited interest in defensive instruments including bonds, precious metals and high-yielding securities. These issues continue to gain ground, despite a broadly resilient stock market that is trading near new highs.

Technically speaking, TLT is engaged in an oversold bounce following a decline to 2014 support between $110 and $120. The uptick has just reached the .386 Fibonacci sell-off retracement level after mounting the 50-week and 200-day EMAs for the first time since October. The still-unfilled post-election gap between $126 and $130 looks like the target of this recovery wave, perfectly situated between the .386 and .50 retracement levels. Look for aggressive sellers to make a stand within that price zone. (For more, check out: Overview of the TLT ETF.)

The iShares iBoxx High Yield Corporate Bond ETF (HYG) posts the highest volume of all bond funds, averaging more than 10 million shares traded per day. It plunged from triple digits during last decade’s bear market, settling in the lower $60s in March 2009. The subsequent bounce stalled in the $90s in 2011, while multiple attempts to break that barrier failed ahead of a 2015 downtrend that posted a higher long-term low at $75.09 in early 2016.

The fund rallied to a 14-month high in October and sold off, bottoming out just three days after the election, in anticipation of stronger demand due to higher growth rates. The subsequent uptick stalled above $88 in February 2017, giving way to a pullback that found support at the 50-week and 200-day EMAs in March. It bounced into April and eased into a rising channel that reached resistance at the first quarter high in late May.

Price action in the past year and a half has drawn a rising wedge pattern at the .618 Fibonacci retracement level of the 2014 into 2016 downtrend. The next harmonic barrier lies at the .786 retracement in the low $90s, but a rally into that level will have to mount wedge resistance, which typically requires significant buying pressure. As a result, strong hands will stand aside and let weaker hands take the bait, while considering a long entry if the fund rallies above the $90 to $91 price zone. (To find out more about this fund, see: Overview of the iShares High Yield Bond ETF.)

The Bottom Line

Bonds are gaining ground despite the Federal Reserve’s latest rate hike, sending mixed messages about U.S. growth in the second half of 2017 and beyond. These recovery rallies still face significant overhead supply, in line with countertrend waves that could attract significant selling pressure in coming months. (See also: The Inverted Yield Curve Guide to Recession.)

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