Thursday, June 07, 2007

Capitulate or die

Today's bond market is a classic capitulation.

Before today, the Treasury market seemed anemic, declining 18 out of 28 trading days since May 1. But each day's trading was fairly benign. The worst single day was +6bps in yield. Technically, I read this as there being very few real-money buyers, but at the same time, not too many sellers (real or fast). So whenever there was a seller, s/he'd push yields a little higher,
but in an orderly fashion.

Meanwhile, it seemed some PM's were hoping against hope that the forecast for rate cuts was still in tact. It seems clear from the stock market action in April and May that this was still the case. I am guilty here also. As recently as May 4 I said I still believed in a Fed cut. And maybe their next move is a cut, but the market clearly believes there won't be any cut for a long while. There just isn't any evidence that the economy is weakening in a way that will ease inflation pressure.

I had thought the Fed would cut once or twice to ease pressure on the banking system. This is rapidly becoming not an option. Central banks around the world are tightening, which will cause the dollar to weaken, all else being equal. A weaker dollar is inflationary (your dollar buys fewer goods, which is the very definition of inflation). To think of it in terms of monetarism, higher interest rates abroad causes capital to flow out of the U.S. If capital flows out, consumable dollars must flow in. Another way to think of this is simple goods competition. If the dollar weakens versus the yen, then Japanese goods are more expensive. Consumers will either accept the higher cost Japanese good (inflation) or buy the domestic good which had been higher priced but is now more competitive (inflation either way.)

So if foreign central banks are tightening, and the Fed just wants to stay neutral, they have to raise rates. To wit, the Fed has never cut rates any time when all three of the Bank of England, the European Central Bank, and the Bank of Japan had hiked rates within the previous 6 months. Nor has the Fed ever hiked when all three were cutting. In fact, when 2 of the 3 were moving in the same direction, there was only two instances (June and August 1999, so really only one) where the Fed bucked the trend. At that time the Fed was hiking as the stock market was roaring. By November, both the ECB and BOE changed course and where hiking rates as well.

Where does this leave the bond market? I've become decidedly more bearish.

1) If the next move by the Fed is a hike, or even if the odds are even for a hike or cut, there should be a positive slope between Fed Funds and the 10-year Treasury. Right now, that slope is still negative. I'd say the minimum level for the 10-year now becomes 5.35%. Probably higher.

2) Corporate and MBS spreads are moving significantly wider. I think its smart to watch this for a good entry point. As I've said before, I don't buy the Asia is getting out of the U.S. market argument. Corporates are more dangerous than MBS, because a Fed-induced recession could cause corporate spreads to widen irrespective of global liquidity.

3) The technicals look very over-sold here. So entering into a short now is tough. As David Andrew Taylor wrote in a recent post, its usually poor investment management to get too worried about timing. But as I said in starting off this post, today looks like a classic capitulation. By that I mean, it looks like there were many accounts who were long the bond market and had been hanging on despite recent weakness. But there comes a time when those longs "capitulate," i.e., give in to where the market seems to be going. This is a textbook capitulation, where a couple weeks of an anemic market culminate in a severe sell-off. Technically, a capitulation is a reversal sign. Take that as you will, I have a firm policy of never making a trade which is contrary to my fundamental view based on technical conditions.

Unfortunately for me, I've been working on various creative bearish strategies and then today happened. So while I did have a small duration underweight, which is helping, had this happened next week, I would have made more out of it. You can't win, but there are alternatives to fighting.


Anonymous said...

What a sensational post!

The only remaining question is, "How far?"

I believe that the end will be deflationary. Really deflationary.

As you point out, the deflationary ball is rolling. I don't see much to stop it.

Accrued Interest said...

I dunno about deflation. We need a lot tighter policy before I'm going to use the "D" word.