Tag Archives: 10-year

The Fed is Cornering Itself

The government shutdown has passed and the markets are still here. The stopgap measures that kicked the can into early next year merely provided a buying opportunity in the interest rate sector for the top 1% while providing the catalyst for the final leg up in a bubble that makes the housing issue of ’07 look like an appetizer. Recent reports suggest that two separate papers presented at the International Monetary Fund meeting this week highlight the potential for a serious revision and extension of the fiscal stimulus plans already in place. Given the current nature of our markets, it’s hard to see how this doesn’t turn sour in the long run.

The Federal Reserve Board has two primary objectives; fostering full employment and stabilizing market prices. Historically, market prices referred to those things in life, which affect all of us like, milk, gasoline and farmland. This perspective has increasingly shifted towards the stabilization of more esoteric prices like the stock markets and interest rates. This shift in focus was originally designed to prop up a swooning stock market as well as getting capital flowing again during the heart of the economic collapse of ’08. The markets came roaring back with equities more than doubling and reaching all time highs this year and interest rates have bumped along at historic lows ever since.

The Fed achieved their goal of stabilizing prices ages ago and it has been proven that each additional increase in Quantitative Easing has been exponentially less effective than the previous one. This path will be followed for the next four years as Janet Yellen is handed the reins of the Fed next year. Why would the smartest minds ignore the data that so clearly illustrates these points? The simple answer is that, “and in other news, the Dow Jones Industrial Average reached another new high today,” sounds like a win to the average John Doe. The truth is that the average John Doe has never participated less in a stock market rally. Furthermore, the headline unemployment rate of 7.2% does not take into account that the labor participation rate is at a 35 year low. Therefore, the unemployment rate as published fails to include 90 million Americans who’ve simply given up looking for work and are drawing no unemployment assistance, thus no longer counting as unemployed.

Recent talk of tapering off the $85 billion per month Fed bond buying programs spooked the equity markets and sent the bond market plummeting, and rightly so. There’s no question that the excess capital created by the Fed must end up somewhere. We’ve seen a full rotation out of stocks and interest rates and into commodities and gold. Now, it’s out of commodities and back into interest rates and equities. The government shutdown created the mother of all buying opportunities in the interest rate sector. You can see the commercial trader buying surge as the Fed’s suggestion in May scared the market. I believe this could lead to the final phase of an interest rate bubble that dwarfs the housing bubble because the big money knows the Fed is too scared to take their foot off of the accelerator and has backed themselves into a corner due to their willingness to manipulate prices on the open market.

We’ve already seen some of the smartest bond money in the world step aside with Bill Gross of Pimco choosing to exit the 30-year bond bull. However, like most smart money, he’s probably early on the way out and will probably miss the last leg up. Although, he was recently quoted about buying the bottom of the shutdown that it was like, “picking up pennies on the street. Somehow, I think he’ll survive. His pennies are not the same as my copper pennies. Banking analyst Dick Bove said on CNBC that the US balance sheet shows us at $16 TRILLION in the hole. Most of this is coming due between 2018 and 2020 as the Fed has taken advantage of lower yields across the board to increase the average length of maturity from 4.1 to 5.4 years since 2009.

Finally, the two papers presented this week will suggest that we EXTEND the length of the QE programs from the original goal of 6.5% unemployment and 2.5% inflation to perhaps 6% or even 5.5% unemployment as inflation is yet to rear its head. The Fed has increased its monetary base from less than $1 trillion prior to the economic implosion to more than $3.6 trillion. If the economic stimulus is the cause of the decline in unemployment from 10% to 7.2%, not counting a quarter of the US population who’ve quit looking for work, then a linear equation suggests that another $1 trillion would get us to 6% unemployment.

Current bond market expectations suggest the 10-year Treasury Note may close the year near 2.25%. That’s approximately 60 basis points above our current price of 126^27. The market would have to reach a new all time high of 133^13 for yields to decline this far. This represents a $6,500 rally per contract in the 10-year Note futures. Given the nature of the bond market, I expect to be able to get this market bought around the 125^00 level and would risk the trade to the 16-day government shutdown low around 122^00. This would provide a risk to reward of $3,000 to $8,400. While we fully intend to trade the bond rally, our primary concern remains focused on what happens once it’s over. The big question remains, “How can the Fed weasel its way out of a situation that they created for themselves while continuing to suggest not only its continuation but, its continuation beyond the original scope of its design?”

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Market Reactions to Debt Ceiling Changes

The ongoing budget and debt ceiling issues have arguably become as contentious as the Trayvon Martin case in social media. This is as vocally divided as I’ve seen my social media feeds. The left claims that the Republicans are solely to blame for our issues while the right insists we cannot spend forever what we haven’t got. Personally, I think both sides have their heads shoved very deeply up a warm and dark bodily cavity. While Congress argues about how to spend our money and money we haven’t got, they receive a lifetime’s salary plus benefits for 4-6 years of work yet have the nerve to use the term, “welfare state,” in public.

Whether you agree with the left, right or somewhere in the middle is irrelevant in the world of managing finances and trading. What matters is empirical data, not conjecture. A quick survey clearly shows that the economy is starting to slow due to the government shutdown. Consumer confidence is plummeting along with Congress’ approval rating. Government loans are being stalled for small businesses. Mortgages are stalling because government guarantees can’t be secured. Customs is turning into a choke point for global trade as inspections can’t be done and clearances can’t be granted. These are all quantifiable drags on our economy and will be reflected in lower GDP numbers.

The previous points are all uselessly valid. We don’t trade US Customs volume and our assets aren’t invested in Brazilian oranges left rotting at a dock. Our assets are directly placed in the US financial markets. I’ve spent the last week compiling a spreadsheet of debt ceiling negotiations and raises (there haven’t been any decreases) from the last twenty years and compared it to the most likely assets to be affected: interest rates, the US Dollar, gold and the S&P 500. Professors always say that economic choices are made, “at the margin.” Our philosophy has always been to stay ahead of the margin calls in the first place.

The debt ceiling has been raised 18 times since 1993. I chose this start date because it gives us 20 years worth of data during the most politicized portion of our history. Furthermore, the past twenty years have participated in the boom of the information age where the average person on the street has had more and more access to more and more information than ever. This allows all of us to make investment decisions based on fully formed opinions on events as they unfold. Therefore, the data set should be representative of the current investment climate.

Based on what has happened in the past, how can we best position ourselves for the future? Unfortunately, the data is mixed, at best. Because I’m old school and still do charting and modeling by hand, I chose a simple premise. “Where did the markets close the day before the debt ceiling was raised and where were they trading ten days later?” The range of results varied little by direction. The most predictable asset class is the interest rate sector by using the 10-year Treasury Note as a proxy. Ten year Treasury Notes traded lower (higher yields) 11 out of 18 times. This seems logical as raising the debt ceiling should force us to pay more in future obligations. It is worth noting that the declines in the 10-year Note came against the backdrop of a 25-year bull run in the interest rate sector.

The S&P 500 was the second most bearish market as it was lower ten days after the announcement in 10 out of 18 instances by an average of 1.6%. The S&P also retained its typical character of panic sell-offs. The largest gain was only 4.82% in May of 2003 while there were four occurrences of losses greater than 5%. Two were greater than 10%. The largest 10-day loss was a whopping 22.7%. Therefore, raising the debt ceiling and conducting government business as usual is not always a positive for the stock market.

The lone bull in the markets examined was the US Dollar. The slight bullishness in the US Dollar surprised me. The Dollar was higher in 10 out of 18 instances by an average of 1.3%. This is where multiple types of analysis really work together. Last week, we suggested that the Dollar is setting up for a downward trending run. I stand by that analysis. Monday, October 7th, Trader Planet published a piece I wrote on the counter trend bounce typically found in the US dollar after multiple moves to new 30-day lows. The Dollar situation as a whole confirms this theory. I expect the Dollar to rally short-term but fall over the course of time.

Gold was the final market we went into. I didn’t expect to find much here and I didn’t. Perhaps, the biggest point to be made here is that anyone trying to talk you into buying gold because the government is failing, inflation is coming, the Dollar is dying, etc must have a hidden agenda. The data simply doesn’t support the sales pitch. In fact, the biggest moves in the post debt ceiling adjustments in gold were to the downside. The general direction however remains a coin toss as the gold market moved up and down with equal frequency over the last 18 instances.

Finally, there’s one last point to be made of historical proportion and I have to credit my brilliant nephew, Erik VanDootingh for tipping me off to it ahead of the news curve. The markets are scared. Big, BIG money is scared. This can best be measured by the difference between the interest rates that the US government is paying for loans versus what international banks are charging to borrow from each other. Technically, this is the spread between Treasury Bill rates and LIBOR (London Interbank Overnight Lending Rate). For the first time in history, including the 2008-2009 implosion, our government is being charged a higher interest rate to borrow money than banks are charging each other. Interest rates are based on risk. The higher the risk, the higher the rate charged. Let that sink in awhile as you ponder, “too big to fail.”

Tidal Shift in the Bond Market

The recent spike in Treasury yields could very well be signaling a change in trend direction. We rarely try to pick tops or bottoms in major trending markets. It simply doesn’t pay. However, we’re seeing lots of corroborating evidence that this may signal a shift in the global macroeconomic outlook. Therefore, this is one of the rare times when a pull back within the interest rate sector may not be a buying opportunity. In fact, if this is the beginning of the Great Unwinding we need to focus on all of the evidence to obtain a complete picture view, all the way from the trading screens to the man on the street.

The trading screens always provide the first clues of market direction. It’s important to remember that prices and yields trade inversely to each other. Therefore, when the price of the security rises, the interest rate declines. The opposite is also true. This is why we can talk about all time high prices and record low yields in the same sentence. The 10-year Treasury Note is the global proxy for US interest rates.

The last leg of this rally began in late November of 2007. The employment situation was starting to deteriorate and interest rate adjustment was the primary tool the Federal Reserve used to pump life into a faltering economy – prior to the economic collapse. The Fed lowered rates by a quarter point in four out of the last five months of 2007. They lowered rates eight more times in 2008 and finally committed to a zero rate policy in February of 2010.

The combined inventive efforts at the Fed eventually drove the 10-year rate to an all time low just under 1.5% in the cash market and an all time low on the 10-year futures of 2.3%. This is where it starts to get interesting. The 10-year Note has been trading at a negative real return for over a year. This means the interest generated by the instrument’s yield would not keep pace with inflation’s erosion of principle. The recent sell off has pushed its nominal yield above 2% while inflation is expected to remain a hair under that mark. Thus, bringing our first, “normal” look at a yield curve in ages.

The high water mark set in early May was fueled in part by Japan’s concerted depreciation of the Yen. The markets were well prepared for this. The US has provided massive stimulus over the last five years. Europe has added their share over the last three years through Greece, Spain and now, Cyprus. The logical next step in a globally competitive devaluation race was obviously a form of Quantitative Easing by Japan. Commercial traders here in the US stocked up on 10year Notes, accumulating their largest long position since February of 2008. Their expectation was that we would continue pushing the zero bound interest rate plan.

This may very well be one of the rare times when the commercial traders are just plain wrong. Historically, they’ve been very good at forecasting rate direction. This time the largest trading group may have been faked out as a whole. Two important points bring this home. First of all, their buying did fuel a rally to new highs…by a hair. Secondly, the weekly chart is beginning to show an obvious reversal bar. Will this turn into an, “Everybody out of the pool,” moment? I doubt it. However, I do expect them to continue to offload recent purchases, which will build up resistance on any attempted rallies.

The other primary point to make is the effect of the rise in interest rates on the housing market and its effect on the anemic economic recovery 99% of us have participated in. The national average 30-year mortgage has climbed by nearly 25% over the last few weeks rising from 3.4% to 4.2% according to Bankrate.com. This will have a big impact on the housing market, which had just begun to clear some inventory. This will also affect mortgage refinancing just as the deadline for governmental forgiveness approaches. The result of the spike in interest rates has caused a decline in the broad S&P 500 of nearly 4%. Meanwhile, the homebuilders ETF (XHB) has declined by almost 10%. The homebuilders have been a primary driver of the broad market’s rally since 2012 gaining nearly 100% in two years.

Higher interest rates are the last thing any of the major economies can afford. Half a decade’s worth of rate cuts, Quantitative Easing and Operation Twist, etc. have created a coiled spring of leveraged money hunting for that last bit of yield. The major reversal bar in the 10-year futures coupled with a large, unprofitable, commercial trader’s position could leave them left holding the hot potato. At its worst, this spike in rates steers us towards stagflation. An environment with rising inflation and no growth characterizes this. How far it spills over into the markets is unsure. Please call with any questions as this may well mark the inflexion point of what has been THE dominant trend over the last five years.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.