Is a Correction Coming in the Municipal Bond Market?

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Although the stock market gets most of the attention, it’s not necessarily the first in pecking order in investment universe.  Not only is this true from a markets movement perspective, it also holds in the courts given bondholder ownership rights trump those of equity owners during liquidations.

The foreign exchange, commodity, and bond markets are also all much larger in size and a primary reason why the stock market is often considered to be the “dumbest” of the asset classes.  More money equals more knowledge apparently.

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The retail, and supposedly less knowledgeable investor, typically also sticks to the equity market (NYSEARCA:XLF) and leaves the bond (NYSEARCA:TLT), commodity (NYSEARCA:UNG), and foreign exchange (NYSEARCA:FXE) investments to the professionals.  This is one reason why valuations can swing so dramatically in the equity market, whereas the other markets are typically much less volatile.

For these and other reasons it often is prudent to pay attention to what these other markets are doing to help confirm or deny what the equity markets are implying.

The municipal bond (NYSEARCA:HYD) market is one of these other markets that has caught my eye and may be warning of higher yields ahead.

High Yield Municipal Debt

Since July, high yield municipal bonds have regained their losses along with the S&P 500, but they also are sporting a large diverging warning sign that the recent highs may be short lived as their uptrend runs out of momentum.

The first chart below shows HYD’s new highs have been accompanied by a diverging momentum indicator.  In addition to recently hitting overbought territory, the fact the Relative Strength Indicator (RSI) has not made a new high along with HYD’s price suggests the recent rally is not as strong as the prior one into June’s top, leaving the current rally susceptible to giving back all the recent gains as buyers are fading away.

In the short term, a price decline below $29.50 (the trend line) will warn HYD has made another short term top and a warning to sell.

The next chart below, however, shows this top may be more significant than just a short term pullback as HYD is also sporting a chart pattern and setup very similar to the pattern formed just before the sizable 10%+ decline in municipal debt in 2013.

In 2013 a similar negative divergence formed with its two price highs.  Compare the pattern then represented by the red dashed lines to the similar one that has formed thus far this year.

HYD ltBack then high yield munis made new price highs, but on less momentum (as measured by the RSI at the bottom of the chart).  This is called a negative divergence as price rises but it does so with less and less momentum – a signal of declining buyer interest.  Within six months from the original peak in momentum (Dec 2012), HYD turned down, falling hard into June of that year.

A similar peak in momentum just occurred in May 2014.  If history rhymes it suggests another Muni bond top may be around the corner.

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A fundamental trigger for such a breakdown in municipal bonds could be the rising rates of the 5 Year Treasury, something I have been following closely in ETFguide’s twice weekly published Technical Forecast.  Since 2013′s high in yields, yields have come back down, but there is reason to believe that correction is over and the prevailing trend of higher yields is resuming.

A rising rate environment no doubt could be a catalyst for another sizable correction in the muni (NYSEARCA:MUNI) bond market.

A break in price below $29 on HYD (second chart) is a longer term sign I am watching to exit high yield muni bonds as 2013’s pattern may be playing out again.  If it doesn’t break $29, no problem, stay long, but if it does, it will be a warning.

In 2013 the decline took prices down over $4.  If the trendline breaks at $29 in another sharp decline, it projects $26 may be seen again for HYD as buying interest is already lagging that of the May price high.

The ETF Profit Strategy Newsletter follows the technical, fundamental, and sentiment levels of the markets to keep our subscribers on the right side of the trends.  A breakdown in municipal debt may accompany a breakout in the 5 -Year Treasury Yield.  Our Technical Forecast shows investors what levels to watch that will warn of the next rise in bond yields and fall in prices.