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August 11, 2010

After watching the bond market rally for the last few months, one has to wonder whether a) today’s statement by the Fed to effectively lower the 10-year yield through re-investment from their mortgage-backed securities was already priced in the market or b) the market realizes that the Fed is running out of ammunition and that lower rates is no longer creating demand in the housing market or for consumers. In all likelihood, it is probably a combination of both factors—and a classic example of why it is important to always ask why a particular market seems to be doing well against the conventional logic. The bond market is comprised of investors that focus almost exclusively on the economy and fed policy, unlike the stock market that often represents a compendium of opinions about individual stocks. As a consequence the bond market is far more likely to correctly discount future events- especially since large players like the Fed are involved that actually make the big decisions that impact the economy. The trend in yields reveals the economic/inflationary expectations and inside information held by these market players . Most of the time, history has show that they are right.

Today if one observed the reaction to the Fed statement they would see that: 1) commodities fell  on the day 2) stocks fell 3) bonds rose -with the 10-year yield bonds leading the way. This seems to support a deflationary thesis–if the market felt that supporting the 10-year bond would be stimulative since it is akin to lowering interest rates, then it would have rallied instead of falling.  In fact, in recent times, the market has actually done better when short-term yields (the 13-week yield) are rising instead of falling. To me this suggests that the market is more afraid of deflation than inflation. It also suggests that rising short-term yields indicate that the easy money is in fact working its way into the economy, and therefore boosting spending,  corporate earnings, and in turn the S&P500. Looking at the action in the 10-year treasury via the TLH exchange-traded fund versus the TIP (inflation-protected bonds) ETF with roughly the same duration we see substantial relative strength favoring the 10-year treasury. Momentum favoring the 10-year over inflation-protected bonds started building in May–which neatly coincided with the market correction. Further supporting the deflationary fears is the fact that commodities (excepting gold and wheat) have been acting very weak for some time–which went against the conventional thinking that the current Fed policy would lead to runaway inflation. The futures show contango virtually across the board–which indicates that either demand is weak or that market players believe that future spot prices should trend lower. (no rational market participant would pay more for prices today than in the future unless there was a shortage–which is backwardation. in contrast, contango–or higher future prices than spot–is normal given the cost of inventory carry and interest rates).

All of this said, I do believe that the bond market is due for a mild correction of sorts. It seems a little too easy to bet on the 10-year in the short-term after the Fed just tipped their intentions so openly, and the fact that the market is already so overbought going into the meeting. From my limited experiences watching/analyzing such events it seems that the big players talk their book up the most right before short-term market tops. I still think that the thesis that deflation is coming and that bonds are in an implausible bull market is something worth taking seriously for the time being.

4 Comments leave one →
  1. Carl permalink
    August 11, 2010 11:04 am

    It would be interesting to see the application of your toolset to intermarket analysis. Just a thought.


    • david varadi permalink*
      August 12, 2010 1:18 am

      hi carl……indeed it is coming soon!

  2. BMB permalink
    August 11, 2010 2:39 pm

    I also think a correction is due. I’ve been holding a large 10y position for many months (since the time when most hedgies were deep on the opposite side of the trade). The fact that it seems most people are finally coming around to my view (deflation now, inflation later) is starting to scare me a little. The recent market action seems like “panic buying”.

    On the other hand, “But why would I want to sell? It’s a bull market!”

    • david varadi permalink*
      August 12, 2010 1:19 am

      hi bmb, my sentiment exactly!

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