How I’m playing the bond bubble

Governments, corporations and private individuals alike have been piling on debt in recent years, spurred on by record low interest rates – and a desire to spend the proceeds. In fact, total global debt today is 40% higher than it was in 2007 – just before the credit crunch collapse in asset markets.

That is why there has been talk of a bond bubble developing. Today, I want to show how I have been playing it.

Central banks and corporations have broken the bond market

The UK government is constantly talking about the need to reduce the deficit, and no wonder. Here is a rather scary chart showing the ratio of UK debt to GDP:

UK GDP chart

The UK debt-to-GDP ratio has more than doubled in only ten years – and is still growing. It is a similar story for other advanced nations (and worse for many developing nations). But despite that, interest rates have been pushed to the floor in an apparent failure of the law of supply and demand.

Of course, one major reason for this apparent failure has been the immense bond-buying power of the central banks. Those banks have been mopping up sovereign debt in their quantitative easing (QE) operations, attempting to ‘stimulate’ economies following the 2008 credit crunch.

Central banks have been the largest buyers of bonds, and are totally price-insensitive. That has allowed the canny banks and hedge funds to ‘front-run’ them by pushing many bond yields into unprecedented negative territory.

This one-way bet became more and more extreme. Now, over €2trn of eurozone debt is at negative yield – a position that was unthinkable until recently.

Over in the USA, corporations have also been on a debt binge:

US corporate debt issuance chart

Note the huge build-up of junk (high yield) debt over the past few years. Much of this is what is termed ‘covenant-lite’, which means that there is ample scope for the debtor to change the payment terms and collateral at will – and even suspend payments if it wishes.

Buyers of this low-quality debt – which now comprises an estimated 60% of all high-yield debt – are extremely vulnerable to default, especially if interest rates suddenly lurch upward.

Debt is everywhere and credit managers are terrified

US consumers have not been laggards when it comes to taking on more and more debt in recent years. Here is another sobering chart (note the slowing of the rate of outstanding credit – a sure sign the US consumer’s credit cards are maxed out):

Deflation chart

Much of high-yield debt rests on the backs of the US consumer, already suffering from low wage growth. Even a slight increase in interest rates would have a major impact on default rates. 

The debt situation has become so worrying that even the credit professionals are concerned. Here is an index showing how concerned they are:

NACM US credit managers index chart

Above charts courtesy

This looks suspiciously like the repeat of the credit crunch of 2008.

This bond bubble has been building for some time, and bond prices have generally been trending upwards.

Something has to give sometime, just as it did in 2008. Back then, my task was to try to identify when the house of debt cards would start to topple over. I believed big profits awaited.

A swing trader can’t just jump in and close his eyes, hoping the market will read his mind. Trade timing is absolutely critical. That is why I developed my tramline system for putting the odds on your side – and I will show how I identified an excellent low-risk trade .

How I played the bond bubble

I focused on stalking the US Treasury market because that market is the biggest debt market in the world. I also have a soft spot for T-Bonds, because this market was one of the very first non-agricultural futures markets I ever traded.

The primary reason I liked the T-Bonds here is that US interest rates determine global rates. When the US Treasury sneezes, UK gilts and German bunds catch a virus.

The market had rallied to a high on 25 May, but on a huge momentum divergence. That was a warning that the rally was probably on its last legs as buying power was waning – and selling was in the ascendant.

US 30-year T-bonds spread betting chart

The market had been following the black trendline, and I was also able to draw a nice short-term tramline pair (green lines). I noted that the market had just broken the long term trendline and was challenging the lower green tramline.

Breaking that could spell the end of the rally – but this market has a habit of taking its time in rolling over.

If we fast forward to today, we can see that the market did indeed have more work to do at the highs. After much churning, the market made a clear wedge pattern, breaking the lower wedge line on 22 April:

US 30-year T-bonds spread betting chart

That was an excellent place to enter a short trade with low risk.

Since then, the market has collapsed by over ten handles (the term ‘handle’ is used for the big number before the decimal point). A short trade taken at the 164 area would see you up by 1,000 pips. Nice.

Naturally, this bond collapse has suddenly been noticed by the media with the term ‘bond rout’ being widely quoted. That apocalyptic language is a signal for the market to reverse back upwards, trapping the late-comers who trade off the media.

But to rack up these profits, you had to have seen what others failed to see in April. Back then, bullish sentiment prevailed. But a swing trader uses this information to base a contrary position, as I did here.

There is little doubt that much damage has been done to the bond markets – T-Bond yields are up by 40% since the January low – with a huge impact on the future interest payments of heavily indebted governments – UK included.

The race to deleverage has started!