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

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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.

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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

From Bloomberg:

US Stocks Fall Most Since June on Microsoft, GE Results

From CNBC.com:

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.
No positions in stocks mentioned.
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