Online Trading Education

The Bond Dilemma

The Bond Dilemma
Geoffrey A. Smith, DTI’s Chief Instructor

Bonds are what make the world go round in the financial markets. Bonds are a lending tool that people use all the time and really don’t realize it. When you take out a mortgage on a house, you are selling a mortgage bond. When you sell something, you bring money in (you receive it), and when you buy something you push money out (you spend it). So when you take out a mortgage, you sell a bond, and you receive the money to pay for the house. In turn, you agree to pay back the “loan” with interest. The riskier the load the higher the interest rate. This will deal with your credit score but also on the current economic conditions as well. As the economy strengthens, interest rates move higher since people have more money and lending increases, but as the economy contracts (weakens) interest rates move down to spur economic growth. So when the economy is doing well, mortgage rates are higher, and in a weak economy mortgage rates are lower.

When buying bonds, you buy then at a specific price and it will have a specific interest rate attached to it. Bond price is inverse to bond yield (the interest rate). It is a simple supply and demand scenario. If I own a bond that yields 5% and interest rates drop to 3.5%, then who wants my bond? Everyone does since they can make more money, so the bond price will be bid up because of demand. If I own a bond that yields 3.5% and interest rates move to 5%, then who wants my bond? No one does since they can get a higher rate buying new bonds, so price goes down.

Now that we have that out of the way, bonds have been very strong (price increasing) this year. Since the price has been moving higher, interest rates have been moving lower. This argues that the growing economy is not growing so well. But the FOMC (Federal Open Market Committee) has been threatening to raise interest rates which would push bonds down. Below is a weekly 30-year Treasury Bond Futures chart. Notice the strong uptrend until recently. Since the Fed has been threatening to raise rates, bonds have been pushing lower, but the trend is still up overall.

Bond Dilemma Graphic

The economy in the first quarter of this year contracted (GDP was negative), which argues that the economy is not strong, but weak, and bonds should be moving higher. But the Fed is saying that interest rates will be raised in the future which will push bond prices down. So then dilemma is which way do bonds go? Should they go up because of the contracting economy, or should they go down because interest rates will be pushing higher?

Because of this question, traders will be hanging on the words of the Fed in the June and July announcements to see if they are still wanting to raise rates, or have they backed off and bonds begin to move back up. Bonds (based off the September contract) have support at 147-00 and resistance at 155-00. This is the current range, and until they break out of this range, we will not have a true direction (again a dilemma). Be patient, only time will tell which direction they will go, but once they break out, we will know where they want to go.

Good luck trading!