10-Year Treasury Yield Weekly Timeframe Source: Bloomberg, PSR
After threatening the 3% psychological round number since April 2018, the movement from the past four months has shown that the 3% level is still widely respected by the markets. The 10-year yield did initially break above the 3% area in April and May, but the bullish move was unsustainable. More interestingly, it was the false bullish breakout above the 3% psychological level that formed the current Head and Shoulders pattern. Head and Shoulders pattern is a bearish formation that signals a reversal move to the downside.
The right shoulder of the pattern was established recently in August as the 10-year yield was firmly rejected by 3.00% psychological level once again. Thus, for the bearish Head and Shoulder pattern to be valid, the 10-year yield needs to break and close below the neckline or uptrend line at 2.84%.
Speculators are currently net short the 10-year bond at an unprecedented level, and it is a perfect setup for the bearish Head and Shoulders pattern to play out. In other words, the herd is currently all positioned on the same side betting that bond prices will continue to fall and yield to keep rising. Bear in mind the bond yield moves inversely to bond prices. However, historically, whenever the speculators are positioned on the same side at a record level, the opposite move tends to happen once the long or short squeeze happens. The speculators provide a good contrarian signal when they are heavily positioned on the same side.
For example, the last time the speculators were extremely short the 10-year bond was in March 2017, when they were at -410,000 contracts. The 10-year yield eventually topped over from 2.62% to 2.01% (-61 bps). To put things into context, the current net speculator positioning is at -586,000 contracts, 42% larger than the previous record short amount.
Hence, once the short squeeze in the 10-year bond happens, expect the 10-year yield to break below the critical neckline. With the larger short position being build up, the next short squeeze will drag the yield down by a bigger magnitude. Based on the Head and Shoulders projection, expect the 10-year yield to head lower to test the 2.50% area.
In addition, with the recent geopolitical turmoil in Turkey with the fast depreciating Turkish Lira causing some emerging market scare, expect safe haven such as the 10-year treasury bond to be in demand. Hence, one can expect the 10-year yield to fall in accordance to trigger the bearish Head and Shoulders pattern for the next wave of downside to begin.
Alternatively, the other way to capitalise on the falling yield environment is to enter into the REITs space. Vanguard Real Estate ETF (VNQ) is a good proxy for the Real Estate market in the US. VNQ tracks the performance of the MSCI US REIT Index. Our study has shown that there is a strong negative correlation between the 10-year yield and VNQ. Thus, with the expectations of yield topping over in the near-term, expect VNQ to continue to perform well.