Trader’s Narrative

According to the most recent Merril Lynch monthly survey, almost 50% are expecting an increase in inflation next year. Although not the highest this survey has seen, this is a pretty high level of bearishness (for bonds).

I mentioned this little known survey a year ago when inflationary expectations were at another extreme.

Merril Lynch’s monthly survey has provided some great contrarian signals for the bond market. In March 2005 it reached a high of 70% (expecting more inflation in the future). That marked an important top for yields (and bottom for bond prices).

Last summer it again saw 70% expecting higher rates going forward. That was another great contrarian signal. Bonds bottomed and started to climb for the rest of 2006.

Earlier this year few (11%) respondents were expecting an uptick in inflation. Which, surprise, turned out to be a fantastic time to sell bonds (see graph below). Back to the most recent data, eventhough we don’t have a real extreme reading, what you have to consider is that the survey was conducted at the beginning of the month, before 10 year yields jumped to 5.3%. Can you imagine the bearishness if the survey was taken after that carnage?

Of course, I don’t think one can trade based on one single indicator. Especially sentiment. But it is valuable when layered on top of other technical indicators and confirms them. For example, the distance from moving averages.

Given the interplay between the bond market and the stock market, this bodes well for equities going forward. That is, assuming that such sentiment translated to price action and we do get a sharp decline in bond yields (rally in bonds).

Maybe my problem is that I try to understand things. So here I am, amid all this hue and cry about interest rates shooting to the moon in order to contain rapidly rising inflation and I find myself asking, inflation? what inflation?

The CRB commodities index broke down from its long term uptrend line last year and has been going lower since. And gold, probably the most watched gauge of inflationary expectations, has just done the same.

Last friday gold didn’t hold the $665 level which was support provided by the long term trendline (see graph). Instead it easily sliced through in a wide range bar and reached a low of $647.80.

Not the sort of price action that is congruent with an inflationary scenario, wouldn’t you think?

I’ve been wary of gold for a while now. But in any case, bonds have been taken to the back alley and beaten to a pulp. Time to buy the panic?

If there is an opportunity, it’s between now and Friday morning - when the CPI numbers will be released. You know the drill: buy the rumour, sell the news.