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Source : http://www.bondtalk.com
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Here are three of the best indicators on bond market sentiment that have reliably forecasted important turns in the bond market:
The Call/Put Ratio on T-Bond Futures
A time-tested indicator in the stock market, the put/call ratio has reliably pointed to excesses in bullish and bearish sentiment. The same has held true in the bond market, which follows the inverse of the ratio—call/put—instead. The most reliable and widely tracked options followed by bond market participants are the options on futures that trade at the CBOT. When combined with other market sentiment indicators, extreme moves in the call/put ratio have pointed to numerous turning points in the bond market for many years.
Although the supply of U.S. Treasury bonds is shrinking relative to the supply of Treasury notes, it is still useful to look at options activity in T-bond futures because there is still a significant amount of speculative activity in that contract. Moreover, T-bonds are not used as a hedging vehicle in the same way that 10-year contracts are for corporate supply, mortgage-related activity, etc.
I have found that the best method for using the call/put ratio is to compare its 10-day ratio against the 1-year average. Over the past few years the 1-year average has been very steady at around 1.10:1. When the ratio has exceeded 1.4, this has frequently forewarned of an impending market decline, owing to excess optimism. At .8 or below, the bond market is generally ripe for a rally, owing to excess pessimism.
Once at these extremes is usually not long before the bond market turns. It is usually a case of weeks, if not days before the turn occurs. Therefore, when you see the c/p ratio at an extreme, seek out possible catalysts that might set the market in a new direction and position yourself accordingly.
As with all indicators, it is best to have confirmation of the apparent excesses in market sentiment from multiple gauges in order to make a judgment about your timing and position size.
Following the index is easy. Simply obtain the data on daily volume from the CBOT’s web site (www.cbot.com) or look for an early morning (pre-stock market opening) mention of all the particulars on my bond wire on TradingMarkets’ Trader’s Wire. If you choose to get the data yourself from the CBOT, just take the total volume of calls traded on T-bond futures, T-note futures, or both depending on the one you’re interested in, and divide by the total volume of puts. That will give you the daily ratio.
Aggregate Duration
In the bond market, it is far easier to track the extent to which portfolio managers are either long or short than it is to do the same in the stock market. And knowing whether bond managers are either long or short can yield important clues as to whether or not there might be tradable excesses in the market.
A great way to get an inside look at the way in which fixed-income portfolio managers are positioned is to follow surveys on aggregate duration. This seemingly obtuse term—duration—is actually less daunting than it seems. Duration is basically a measure of a bond’s price sensitivity to changes in interest rates. It is akin to the beta on a stock. The longer the maturity of a bond, the higher its duration. When portfolio managers want to increase their level of risk, they raise the duration of their portfolios by increasing their average maturity.
Aggregate duration surveys capture the extent to which fixed income portfolio managers have collectively adjusted their level of risk taking. Most duration surveys include portfolios that have a combined total of several hundred billion dollars in assets or more. In fact, one survey, conducted weekly by Ried Thunberg, includes portfolios that have over $1trillion in assets. Since the bond market is largely an institutional business, the surveys are therefore a great microcosm of the risk profiles of the universe of fixed income portfolios.
In the best of the duration surveys, Stone and McCarthy’s (www.smra.com) survey has shown that fixed income portfolio managers consistently maintain their duration levels at between 95% and 105% of the their benchmark—the index that their performance is judged against—usually the Lehman index. When portfolio managers are bearish, they reduce their exposure in the market to below that of their benchmark so that if the market falls, their portfolio will outperform. Similarly, when pm’s are bullish, they raise their duration to over 100% of their benchmark’s duration, hoping to outperform their benchmark on the way up.
Aggregate duration is generally maintained between 95% and 105% except under extraordinary circumstances such as in 1998 during the World Financial Crisis. This probably relates to the conservative nature of investors in the fixed income asset class. For us traders this is a big plus because it makes it easier to judge whether the market is at a bullish or bearish extreme.
The analysis and how you should act, therefore, is rather simple. When aggregate duration falls below 100%, this suggests that portfolios are short. The more they move toward 95% (think about it as 95% long relative to their benchmark), they shorter they become. At 95%, the market is extremely oversold and is ripe for a reversal, and you should be positioned accordingly in both equities and bonds. Of course the opposite holds true when portfolios have duration of greater than 100%. At 105%, the market is extremely overbought and set to fall.
Those are the extremes but 97% and 103% can also be seen as an extreme for intermediate trends. Moreover, if you believe the fundamentals do not fit with any duration levels, you might consider the market long or short based on your own subjective analysis.
Aggregate duration can be tracked by following several economic and fixed income services companies including Ried Thunberg, which conducts their survey every Friday, Stone and McCarthy(every Wednesday), and Thomson Global Markets. In addition, most primary dealers conduct their own surveys, and you might be able to get the information that way. I strongly recommend tracking Stone & McCarthy’s duration survey as it has had the best correlation with the market. All of the surveys that I mentioned are reported by the major new services and can be tracked that way as well. Alternatively, follow the indexes on my web site, bondtalk.com, by going to “market indicators,” using the left navigation bar on the home page.
The 2-year T-note As a Benchmark
There's often confusion over the U.S. Treasury maturity that investors should follow as the benchmark for U.S. interest rates. While it is common practice for most to refer to the 30-year T-bond and, increasingly, the 10-year T-note, there is another often overlooked maturity that gives an excellent guide into the potential excesses in the bond market: the 2-year T-note.
Perhaps the biggest signal that the 2-year T-note gives pertains to the bond market’s sentiment toward the Federal Reserve. Over time, the 2-year has been a reliable indicator mainly because of its stable relationship to the fed-funds rate, the rate controlled by the Fed. During periods when the 2-year has deviated from its historical relationship, this has pointed to the bond market’s true underlying feelings about the future direction of Fed policy. In many ways, it has been a more accurate gauge than fed-funds and eurodollar futures.
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