Bond traders are trying to work out how they can justify buying U.S. Treasuries when the notion that inflation is still rising, albeit at a cooler pace. The big problem is that inflation is still up some 20% by some measures when compared to where it was prior to the pandemic.
If bond traders can work this quandary out, we may see a big move in the homebuilders and real estate related stocks.
If you’ve been paying attention to the intraday trading patterns in the stock market, you’ve probably noticed that gains in stocks tend to be more prevalent when bond yields are falling and that on any given day, those gains often fade when bond yields rise. We saw this in full display on 11/13 when the CPI number was first seen as benign but bond traders reversed their bullishness by the end of the day. We saw the script flip, at least in the early going when PPI came in along the same lines with inflation still rising but perhaps more slowly.
Image courtesy of https://www.ekathimerini.com/
The reason I spend so much time on what’s happening in the bond market is simple. Rising bond yields are a sign that liquidity is fading. And periods of low liquidity tend to dampen rallies in stocks.
Moreover, lower interest rates are bullish for homebuilder stocks and real estate investment trusts (REITs), especially REITs which specialize in housing rentals (single and multifamily). Even more important is that the housing sector accounts for 16% of U.S. GDP, which means that anytime housing slows, almost 1/5 of the U.S. economy slumps.
I recently made a sector wide recommendation on the housing sector in a post which included several homebuilders, and a lumber stock. The call was based on the premise that bond yields are closer to topping out than to move higher. That’s a risky view point, but one which is worth exploring, especially in terms of how bond yields affect mortgage rates and how a reversal in their current rise could influence current market trends.
We’ve Seen this Before
Way back in 2023, I wrote a piece describing the bullish trend for homebuilder stocks that erupted as the Fed made it clear that it was done raising interest rates and bond yields crashed below 4%. Yet, as the two year price chart for the U.S. Ten Year Note yield (TNX) shows bond yields have delivered two momentous tops over the last few years.
The first one was back in July-August 2023 as TNX moved well outside the upper Bollinger Band corresponding to the 200-day moving average. When any financial instrument moves outside the upper band corresponding to the 200-day moving average it signals a secular (very long lasting) change in the trend. Note that move took TNX to 3.8% in its first leg and then down to 3.65% in its second leg which began in April 2024.
It’s also important to note that the down leg in yields which began in April 2024 was essentially a reversal of the event which occurred in July-August 2023. That’s because TNX fell outside the lower Bollinger Band. In essence, the current rise in bond yields is the direct result of that long term reversal of the trading pattern.
It’s important to note that the top in yields in 2023 was not just triggered by the rise of TNX above the upper Bollinger Band, but also by an RSI reading above 70, signaling an overbought situation. For its part, the April 2024 reversal was accompanied by two tags of the RSI level of 30, along with the move outside the lower Bollinger band. Both occurrences signaled an oversold situation
All of which leaves us with the present situation, one with the following characteristics regarding TNX:
• The yield is trading inside the Bollinger Bands – a normal trading pattern;
• TNX is above its 200-day moving average confirming the reversal from the August bottom;
• The RSI for TNX has recently tagged the 70 level signaling an overbought situation;
• Yields have risen despite the tag of 70, which is a technical divergence; and
• TNX is testing the 4.5% yield area.
• It’s also important to note that this two year chart shows that each top in TNX is lower than the previous. Lower highs and Lower lows are the hallmark of a bullish trading pattern.
So, what’s my point? Bond yields could certainly trade higher. But given their recent overbought status a short to intermediate term reversal is within the realm of possibilities, which is why I recommended the homebuilders recently. I admit that the trade may be painful in the short term. Yet, given the tilt toward tight supplies in housing, homebuilders still get the benefit of the doubt.
And why would bond yields suddenly drop? A recent post by Gianlucca Benigno of The Central Bank’s Watcher Substack, sheds some useful light on the subject. And while the entire post is worth your time, the short version is that the rate of rise in inflation might have topped out. If that view becomes widely accepted in the bond market, we may see that drop in yields that I’ve been writing about for the past few weeks.
In the Field Observations
I took a longer tour than usual of the on the ground projects I’ve been watching for some time. There are large numbers of apartment complexes that have either been completed or are on the verge of completion. Moreover, some of them are already starting to fill, albeit with heavy incentives such as two free months of rent with a year’s lease.
The commercial side of the ledger is also busy with several entertainment venues accompanied by restaurants and shopping areas in the vicinity taking shape.
The laggard is single family housing, which remains sluggish except when it comes to townhomes and gated communities targeting upper income clients. There is lots of traffic in existing homes, but sales remain scarce.
Homebuilders and REITs Are Still Consolidating. A Potential Big Move is Starting to Take Shape.
The iShares Home Construction ETF (ITB) is still trading in a consolidation pattern closely tied to the fate of bond yields. A meaningful drop in the U.S. Ten Year Note Yield (TNX) is likely to move this ETF higher.
You can see a similar trading pattern in the iShares U.S. Real Estate ETF (IYR) with one subtle but important difference. The OBV line (a sign of buyer activity) is starting to rise in IYR. This is a sign that dip buyers are stepping up. On the other hand, you can see that both ADI lines (a measure of short seller activity) are falling for both. When the OBV lines and the ADI lines diverge it’s often a prelude to a short squeeze. Also note that the Bollinger Bands are tightening around prices on both ETFs. This is a sign that a big move is near.
Meanwhile, mortgage rates are likely to drop if today’s action in the U.S. Ten Year Note yield (TNX) continues.
Bottom line
The housing market is, more than ever, a prisoner of the bond market. Bond traders are groping with the notion that maybe it’s ok to buy bonds even as inflation is slowing but not falling. If they can work this issue out it sets up the potential for a bullish move in homebuilders and REITs if bond yields break below key support levels.
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