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Charting a Course Balancing Open-Ended QE and the QE Asset Reflation Correlation Trade


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.

MINYANVILLE ORIGINAL 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.
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