Throughout the month of October I have been working off two main themes: 1) that open-ended QE would bring about increased bond market volatility and 2) the consensus QE asset reflation correlation trade should be faded. This week I want to expand on these two themes and try to chart a course for how they may play out over a busy couple of weeks and into the holidays.
Next week we have an Federal Open Market Committee ("FOMC") meeting, the following week is month end (which is also many fund manager’s year-end), and Friday November 2 we'll get the October jobs report. Oh, and there is a fairly important event on the first Tuesday of November.
On October 1 in The Unintended Consequence of Open-Ended QE
I cited the key 150-00 level in the US bond futures contract and discussed the volatility that could surround this pivot that has confined the market since the beginning of summer.
The bond contract traded right back to the influential 150-00 pivot level I have been watching, which provided stiff resistance despite a slew of weaker than expected economic data. Since the Fed announced QE the volatility in the bond market has been intense, and I think this is indicative of how it will trade for months to come.
When I sent out this article to my email distribution list I concluded with the following comment:
With the opportunity cost of cash virtually zero I think you can afford to be liquid and opportunistic. Currently the MBS market has QE priced for infinity but as long as it may last it won’t be that long. Don’t allow yourself to get sucked into the notion that duration and convexity will remain subdued. I think there will be a lot of action in the long end of the curve as this QE discount gets reconciled. Also the 150-00 level on the US bond futures contract continues to be a very important pivot. I will respect a move from that level in either direction.
The ensuing weeks would see 150-00 resistance hold and reverse in consecutive moves, first failing at resistance and falling to the 147-18 level into that first weekend. The following week the contract rallied back into 150-00 finding resistance again on that Friday. This past week we sold off hard, making a lower low on Wednesday and finally finding support at 146-08 on Thursday. Friday the contract bounced from oversold conditions and on weak stock prices, rallying over a point to close the week at 147-18, which happens to be the under side of the previous low. This is not coincidence. The 150-00 pivot is real and has become the battleground for the entire bond market.
Now the opportunity cost of cash isn’t really zero, but the absolute and risk adjusted spreads had gotten to a level where you were not paid to sell volatility. That said though, for the liquid and opportunistic investor, volatility became your friend. Being patient, I had declined to chase rallies and buy paltry risk premiums, however last week as yields rose and spreads widened I became more active to take advantage of the volatility. For institutions that have to put money to work regardless of price it’s not enough to just simply fade the rallies. To be tactical you have to stick to a strategy and be willing to step in when the market is for sale. I am not trading the market so to speak; I am merely allowing the volatility to work for me, and this strategy has provided significant basis point savings, which is all the more valuable in this low-rate environment.
With an FOMC decision slated for Tuesday the market will no doubt be on edge as it awaits further indication on the Fed’s QE intentions. To give you an idea of what the committee will be looking at during the meeting, consider the price action in the MBS market. When the Fed announced QE III that would focus on lowering mortgage rates at the September 13 FOMC meeting, the Bloomberg MBS current coupon FNMA 30YR index was at 2.12% at a spread of 40bps to the 10YR UST note. Friday that index closed at 2.22% at a spread of 45bps.
With the exception of banks, insurance companies, mortgage REITS and a few fixed income hedge funds most investors aren’t concerned with the effects of QE on the MBS market; they are concerned with risk assets. On October 8 in A Global Macro Paradigm Shift
I posited whether the consensus was correct in assuming the market would behave the same under QE III as in QE II.
If this paradigm shift is underway it presents a very tricky and potentially volatile environment for investors because the old rules will not apply. The consensus trade coming out of QE III is to get long the same reflation trade that defined QE II, short the US dollar and long risk assets which had also defined the old US/China paradigm.
This Sunday morning PIMCO’s
Bill Gross tweeted
: "Don’t fight central banks but be afraid of inflationary consequences. Buy what they want you to buy – for now: risk assets."
I’m not sure it will be that easy. Since the QE III announcement markets have not followed the old playbook as the correlation trade has somewhat broken down.
After Friday’s 25 handle drubbing in the S&P 500
(INDEXSP:.INX) the headlines attributed to the weakness to poor earnings and revenue reports out of Dow
(INDEXDJX:.DJI) bellwethers GE
(NYSE:GE) and Microsoft
(NASDAQ:MSFT). However having identified the market risk ex ante I knew better.
From the Wall Street Journal:
Falling Revenue Dings Stocks: US Companies on Track to Report Lower Sales for First Time in Three Years; Dow Falls 205 points
US Stocks Fall Most Since June on Microsoft, GE Results
Stocks ended sharply lower across the board Friday, logging their worst one-day drop in almost four months, pressured by disappointing quarterly results that highlighted the global economic slowdown.
In my view this is an incorrect interpretation of what’s going on. The market followed one of the worst weeks since the June 1265 low with one of the single worst days, and it’s not because earnings are weak. Trust me, the market is well aware of the poor economic conditions, especially during the third quarter, which is producing the weak earnings and revenue reports. Since the June low that has seen a 15% rally we have had three consecutive months of sub 50 ISM data releases suggesting a contracting manufacturing sector and near recessionary conditions. The weak economy is not the story. To understand what is driving market dynamics you have to understand that there is a difference between market prices reflecting discount and market prices reflecting flow. The market hasn’t been rallying on a growth discount; it’s been rallying because of the flow of underexposed investors, namely the hedge fund community. Back in June I noted this discrepancy In Trading the Wrong Playbook Bubble
At the same time that the Fed was taking the discount out of the discount rate, we saw an explosion of financial analysts, investment bankers, and so-called alpha-generating hedge fund managers all using the same playbook based on valuation models. So while the Fed was making valuation irrelevant, more and more investors were relying on and utilizing the same valuation models to make capital allocation decisions.
The massive underperformance of the investment community is attributable to a wrong playbook bubble. This market cycle doesn’t care about growth or discount, it cares about positioning and sentiment.
I noted the outsized September performance of Long Biased Hedge Funds as an example of this market flow dynamic.
With a 5% gain on the month while remaining down on the year it’s pretty clear to me that this performance grab has been largely responsible for the push to new highs. No doubt the underexposed speculative community has been pushing prices higher as they cover and get long.
This is also evident in the CFTC commitment of traders
report in the E-mini S&P contract (ES). Large speculators, aka hedge funds, had been net short for over a year until they finally covered and went long in September as price broke through the 1400 level. Friday’s report showed the large specs entered the week long 135k contracts. With the exception of one week in 2011, this is as long hedge funds have been since Q1 2010.
Understanding how this market dynamic is in play is key to identifying the risks in the stock and bond markets over the coming weeks.
Friday ES closed at 1424, not far above the level that brought hedge funds to cover. Next week we should at a minimum expect the market to test the area between 1425 and 1400. For the rally to stay in tact hedge funds will have to defend this area. If 1400 gives, the main buyers will then be under water and presumably turn sellers, putting a lot of pressure on the market. If 1400 holds, you should expect an attempt to rally the stock market to new highs possibly into month end and into year end.
In terms of the bond market I do not want to assume that what’s bad for stocks is good for bonds and vice versa. As I have repeatedly said the 150-00 level on the US bond contract is real and must be respected regardless. After Friday’s rally the US bond contract is entering intermediate resistance at both price and momentum between Friday’s closing level up to 148-00. With the Fed on deck Tuesday and with stocks poised to test lower levels, investors should expect the market to challenge this area. Nevertheless bond market price action needs to be interpreted independently of stocks market price action. Most investors who are buying the QE asset reflation trade are focused on stocks and commodities which are most sensitive to dollar devaluation, but perhaps there is no asset that has been reflated more than US Treasury bonds. Not only are they the obvious target of Fed intervention, the excess dollar liquidity being created also has created excess demand for dollar assets.
It will be an interesting FOMC meeting on Tuesday because since launching QE III at the previous meeting, nothing that you would assume to reflect this reflation (including Treasuries) has responded as expected. In fact you might say that many assets have actually deflated. Here is where it gets even more interesting in what could define the trade for 2013. Is it possible that both stocks and bonds go down at the same time?
The Fed could potentially be a victim of their own success. By being so egregious in their attempt to manipulate the market pricing mechanism and by also boasting about it they have put themselves in a box. If and when the market doesn’t behave the way investors think it should, at least when the Fed is inflating, investors will start to lose faith that the Fed is in control. Imagine if the assets that the Fed is trying to reflate all start falling. If that happens that could be a very dangerous situation for all markets including the bond market and the US dollar.
Most investors are looking toward 2012 worried about the results of the election and whether the fiscal cliff gets resolved. These are the known risks. The unknown risk is what I am worried about. To me that is how and when QE comes undone. The big trade in 2013 might not be about the effect of a fiscal policy debacle; it might be about the effect of a monetary policy debacle.