2014 was supposed to be the year to dump bonds, yet surprisingly, bonds have been the surprise winner this year. But that may soon change, if one noted market observer is correct.
Larry McDonald, senior director at Newedge, predicted the subprime mortgage crisis (and the subsequent collapse of his old firm Lehman Brothers) two years before it happened. He now says interest rates are headed higher.
(Read: Treasurys decline after weekend elections)
"The whole street now is predicting a second-half strong recovery," McDonald said. "Every analyst is looking for a strong second half. And, if they're remotely right, then we're going to have a short-term reversal in yields."
According to McDonald, the recent drop in yields on the benchmark 10-year Treasury note had more to do with the unwinding of a large position by one player last week than a true indication of what is to come.
"Someone had …a big bet that interest rates would rise," said McDonald. "They were likely long 2-year Treasurys versus short the 10-year note. Short covering lead to more short covering as falling yields (rising bond prices) forced other bond bears to cover their shorts as well."
"This looks, feels and smells like a capitulation climax—one big short squeeze," McDonald added. "But when they’re done covering, look for interest rates to rise."
McDonald lists seven reasons why he thinks bonds rallied, thereby bringing about a bottom in yields:
1. A surge in global disinflation, which is great for bonds.
2. China’s subprime shadow banking crisis has many taking down global growth estimates.
3. High geopolitical risk in Ukraine.
4. A more dovish Fed: Recent Fedspeak has been more cautious on economic growth outlook than many expected.
5. US housing market: New home sales have been coming in much less than street expectations.
6. Fed Fund Futures are not pricing in the first Fed rate hike until October/November 2015.
7. A more dovish ECB makes U.S. bond yields look attractive relative to Spain, Italy and others.
McDonald says now is a good time to short bonds, and he’s using the ProShares UltraShort 20+ Year Treasury ETF (TBT) to express his view.
(Read: Economists lift 2nd-quarter US growth forecasts: Philly Fed survey)
"You just see a tremendous amount of people exiting in a very short period of time relative to the total amount of shares outstanding," said McDonald about the TBT. "That's the sign of a near-term bottom in the ETF. As well, we've also seen a discount to net asset value in the ETF at the same time. So, when those two things line up—a discount to net asset value plus a tremendous amount of capitulation volume in a short time—that's a sign of a near-term bottom in the ETF."
To see the full interview with McDonald on the TBT and interest rates, watch the above video.