The Most Important Market No One Is Watching

By Vince Foster  SEP 10, 2012 10:15 AM

You can't have stronger nominal growth and lower interest rates. When the market begins to discount may be anyone's guess, but it will most certainly show up in the bond market.


MINYANVILLE ORIGINAL Last week’s bond market price action in the long end of the curve against a stock market that still wanted to rally despite deteriorating fundamentals could be a harbinger of things to come if and when the Fed launches QE III.  The stock market seemed oblivious to the headlines while the bond market traded with insane volatility.

Tuesday we got yet another ISM print that showed contraction in the manufacturing sector with an even more troubling inventory to sales ratio.  Ho hum.  Wednesday the ECB leaked Mario Draghi’s open-ended bond-buying program.  Blah blah.  Thursday we got a much stronger than expected ADP report alongside better unemployment claims, and pre-open, the stock market seemed to just take it in stride.  Whatever. 
The bond market, on the other hand, was under pressure.  US bond futures were slicing through the key 150-00 pivot down over a full point.  Then when the bell actually rang stocks got the message and were off to the races with the S&P 500 (^GSPC) rallying 30 handles on the day eventually closing at new cycle highs at 1432. 
The bond market was clearly anticipating and positioning for a big non-farm payroll number on Friday.  Pre-open the long bond yield was up 6bps and bond futures were down another point to 148-16.  Then the NFP data hit with a resounding thud.  The data was so weak you couldn’t even count on the perma bull cheerleaders to paint any lipstick on the pig.  It was truly horrendous. 
The bond market quickly turned with the US bond futures gapping higher by 1.5 points.  Stocks, on the other hand, barely budged.  It was like they weren’t even awake.  I think the S&P futures were down like five handles at the lows.  Bond futures, however, were jamming higher, and by the time stocks were opening, were approaching the 151-00 level almost 2.5 points higher than pre the NFP release.  When stocks opened and just shrugged off the data, bonds suddenly found no bid and reversed lower.
By lunchtime the bond contract traded all the way back down to the 149-16 level basically where it closed on Thursday.  The S&P finished the day up five to close at a new cycle high just shy of 1438 while the bond contract settled at 149-09 just off the afternoon lows and below Thursday’s close. Yesterday at lunch I picked up a copy of the New York Times and this is how the Saturday edition of Stocks and Bonds would characterize the bond market’s wild ride:
The Treasury’s benchmark 10-year note rose 3/32, to 99 20/32, and the yield fell to 1.67 percent from 1.68 percent late Thursday.
That’s it; one sentence.  There was a lot of talk about employment, stock market resiliency, QE III, and the warning from Intel (INTC) but nothing on the bond market.  Let me tell you there is no more important market in the world right now than the US Treasury market and there may be no more important security than the 30-year futures contract.
When I was beginning my finance career I spent a few months as a desk jockey on the middle markets fixed income desk at Bear Stearns in Atlanta, GA.  At the time, Bear Stearns was well known for its presence in the mortgage market.  The infamous Howie Rubin was head CMO trader at Bear Stearns and my manager was a semi-retired mortgage trader who had previously worked in New York.  His name was Bob Shoemaker. 
I really don’t recall ever seeing Bob much look at Bloomberg or his computer screen, or pick up the phone to call a trader except maybe to exchange a funny story.  He pretty much read the paper all day long while responding to typical managerial duties.  Yet during the day, randomly and out of the blue, he would shout out across the desk, where’s the contract?  John Shapiro, who was the youngest but also probably the smartest producer on the desk, would quote him.  Never even putting the paper down, Shoemaker would respond with his order.  Take it!
The contract is the 30-year bond contract traded at the CBOT.  Bob and John would trade it like this all the time.  I became fascinated.  Bonds weren’t just something you buy and hold to maturity; they are just like stocks or anything else you actively trade.
Months later I would go visit my cousin in NYC, and I asked Bob if he could get me on the trading floor at Bear.  He did, and I got to spend a slow Friday on that historic desk with the mortgage pass-through traders.  That experience was all I needed to know that I didn’t want to just work in the securities business, I wanted to work on a Wall Street trading floor.
I didn’t make it in mortgages, but I was given the opportunity to work for one of the best bond trading firms on the street, Greenwich Capital Markets, where I was an assistant in the portfolio strategies group.  Though at Greenwich I wasn’t getting coffee, making copies, and cold calling like at Bear Stearns in Atlanta, I was picking up the phone and trading.  And this wasn’t odd lot agencies and munis, this was block size Treasury trading on the wire.
One of my main responsibilities was executing interest rate futures trades at the CBOT and CME.  I traded a lot of bond futures during that time and I soon realized why Shoemaker called it the contract.  The 10-year futures ("TY") is what you trade when you need to hedge interest rate risk such as mortgage convexity hedging, the contract ("US") is what you trade when you want to speculate.
There are legions of self-proclaimed “macro” strategists and hedge fund managers who cite and trade the (TLT) bond ETF.  It’s one thing for a retail investor to trade TLT, but there is no self-respecting bond strategist or fund manager that has even ever uttered the letters TLT.  Trust me you will never see CRT’s David Ader cite TLT and you won’t see Paul Tudor Jones trading it.  If you want to know what the bond market is doing you have to watch the contract.
Friday the contract did its thing.  Watching the price action pre and post NFP, there was no disputing which way the speculators were leaning, and when they covered on the gap, there was no bid behind.  Casual market observers like the New York Times brush off the price action as irrelevant to the story, but I am here to tell you it’s the whole story.
Since the miserable June NFP that only saw 45K jobs added, the contract (Dec now front month) has been confined to a range with the big pivot at 150-00 which is the same level that was tested in Thursday and Friday’s intense volatility.  This is not a random coincidence.  The market is battling in here.
The volume in the pits on Friday in both the TY and US of 1.45mm and 503m contracts respectively nearly turned over their total open interest. The notional dollar value of the volume represents $195b.  Can they really control the entire market just buying a couple billion in cash a day?  Regardless Friday demonstrated that Ben Bernanke faces a potentially dangerous bond market paradox. 
Friday the action in the yield curve told the whole story.  The belly, 5-year and 7-year led the performance finishing better by 3bps and the 5-year/30-year spread finished 6bps steeper on the day.  The steepening bias in the curve was a clear message that the bond market is preparing for a higher inflationary discount as the result of QE III. Operation Twist was balance sheet neutral and focused on the long end of the curve, but presumably QE III will expand the balance sheet.  This is where it gets tricky for Bernanke.  Unlike Operation Twist, the QE III paradox is that the Fed will be attempting to lower interest rates while making them more negative by engineering higher inflation; i.e., they will be raising the value of bonds while making them worth less.
Bernanke would tell you that QE has been successful in lowering interest rates, but think about it.  The 10-year yield didn’t fall toward 1.50% until after QE II ended.  On June 30, 2011 the 10-year was at 3.15%.  It wasn’t until he balked at more QE and blew up the risk asset reflation correlation trade did bonds catch the bid.  You may also recall that when they launched QE II in November 2010 the 10-year was at 2.50% and over the next four months rose over 100bps as the curve steepened on the inflation discount.
Last Tuesday the US national debt crossed the $16t mark.  At the time of this writing it’s already $13b higher and moving fast.  At the end of August the amount of outstanding Treasury debt was approximately $11.27t vs. $10.0t this time last year and v $6.9t in August 2009.  The stock of Treasuries has grown by 63% in three years which is 5x the rate of nominal GDP growth over the same time frame.  The supply is growing at an alarming rate and absent the Fed and foreigners, there are no natural investors in US Treasuries, only speculators front running Fed intervention and a blow up in Europe.
You can’t discount the influential bid in the bond market from the flight to quality out of Europe.  With last week’s ECB announcement from Mario Draghi that they are prepared to unleash unlimited bond buying it’s a wonder how long this fear bid will last.  There has been a material fall in peripheral bond yields, especially in the front end where banks likely own.  In addition a favorite proxy for European risk premiums, the EURUSD cross currency basis swap has been rallying and is as tight as it’s been since last summer.  Since June as the bond market has been battling its range, the 1-year EURUSD basis swap has tightened by 40bps which has more that cut the risk premium in half.
Relying on speculators and a fear bid to keep the curve together while you are inflating the coupon could turn into a dangerous game.  It looks like the fear bid could be waning and speculators can turn on a dime.  If the trading range that has confined the contract since June breaks to the downside the pressure could be on.  In addition to the crucial 150-00 level I have lower pivots of 148-00 and 146-16.  These levels should be respected if tested and I would not fade the move from these big pivots in either direction.
Coming out of last weekend’s Jackson Hole symposium, perhaps no paper/speech delivered garnered more attention than the one titled Methods of Policy Accommodation at the Interest-Rate Lower Bound by Columbia’s Michael Woodford.  I didn’t have the patience to read the whole thing but in scanning parts he discusses the policy of “forward guidance” and potential targeting of nominal GDP:
An alternative that I believe should be equally easy to explain to the general public, but that would preserve more of the advantages of the adjusted price-level target path, would be a criterion based on a nominal GDP target path, as proposed by Romer (2011) among others. Under this proposal, the FOMC would pledge to maintain the funds rate target at its lower bound as long as nominal GDP remains below a deterministic target path, representing the path that the FOMC would have kept it on (or near) if the interest-rate lower bound had not constrained policy since late 2008. Once nominal GDP again reaches the level of this path, it will be appropriate to raise nominal interest rates, to the level necessary to maintain a steady growth rate of nominal GDP thereafter.
Recall on July 30 in Bernanke’s Astonishingly Good Idea that I thought you would start to hear more about nominal GDP targeting as a policy option and investors must be aware of the effects on inflation discounts in the dollar and bond market.
Something like the purchasing of private assets indeed could be Bernanke’s nuclear option, and it’s quite possible he bypasses the banking system to inject the liquidity. 
I think we will start to hear more about a program along the lines of a nominal GDP (NGDP) target that is used to justify direct purchases of private assets. 
The trick for a nominal GDP target is what the targeting output gap you are trying to achieve.  Some have it as high as $17t vs. today’s level of $15t.

Regardless you are still talking about creating a few trillion in nominal growth (i.e. inflation) out of thin air over the next couple of years.  How do you do that when consumers won’t borrow?  It goes back to the “helicopter drop” Bernanke cites in his speech or purchasing private assets.  It sounds crazy but what if they in effect just mail everyone $10,000 or offer to buy used computers, flatscreen TVs, upside down SUVs and condos in Florida at 2x the value.  It’s no crazier than a money financed tax cut.
In operating Fed policy since the crisis Bernanke has been using the playbook he outlined in his helicopter speech from 2002.  Thus far policies have focused on easing credit conditions so that banks will lend.  But can you successfully recapitalize an overleveraged economy with more leverage?  A bankrupt company does not take on more debt to recapitalize, it converts debt into equity.
Bernanke’s nuclear option is a money financed tax cut but that is not feasible in today’s political environment.  I said it sounds crazy to mail everyone $10,000, but is it really?  The output gap is $2t.  Instead of easy credit or a money financed tax cut why not just extend cash equity.  What’s the difference?  Take the roughly 140mm tax payers and give them all $10,000 cash instead of credit.  Bernanke has already printed $1.6t.  What would have happened if instead of giving it to the banks he gave it directly to the consumer?  Instead of extending credit through the banking system he should be extending equity.  Instead of a credit card it should be a pre-paid debit card.
If the Fed did go nuts and drop money from the skies they would be naïve if they thought it would not elicit a severe market response.  The inflationary tail risk would likely manifest itself in an immediate collapse in the US dollar and a corresponding rise in long term interest rates. 
This cat-and-mouse beating-around-the-bush game the Fed is playing with the markets is getting very old.  If the goal is to trash the dollar and inflate nominal growth anyway the Fed should at least give the money directly to the people who have to bear the consequences.  By sticking it in the banking system and on trading books of primary dealers, the Fed is only creating the inflationary market discount which consumers inevitably pay but don’t get the money with which to pay it.
Regardless of whether QE III is an implicit target of the output gap or an explicit one, the goal is the same.  Bernanke knows employment won’t come down with the output gap in place and it doesn’t seem he will stop until he closes it.  There is no doubt that the inflationary path to close the gap produces a steeper yield curve and higher long-term interest rates. 

Bernanke can’t have it both ways.  He can’t have stronger nominal growth and lower interest rates.  When the market begins to discount this reality is anyone’s guess, but I am certain it will show up in the bond market, and more specifically, in the contract first.

Twitter: @exantefactor
No positions in stocks mentioned.