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Amid Stock Market Euphoria, the Smart Money Is Fading


Perhaps the smartest of the smart money operate in the US Treasury market, where the most glaring divergence is occurring.

With hedge funds now in charge of the stock market it remains to be seen how they will conduct themselves as we embark on the second quarter and into the summer which have been seasonally weak since the 2009 low. In fact we saw similar hedge fund buying in the first quarter of 2010 and 2011 that both preceded nasty corrections. If history is any guide they are quick to head for the exit at the slightest hint of a change in momentum, and it's not clear where the smart money bid comes back in to absorb what is a large supply of levered longs.

Perhaps the smartest of the smart money operate in the US Treasury market, where the most glaring divergence is occurring as yields on the long end have fallen 20bps in the past three weeks. You will recall one of the primary catalysts equity bulls have been citing as a reason this rally has legs is what is referred to as the "great rotation" out of bonds and into stocks. I tried to debunk this nonsense back on January 28 in The Great Rotation? The Market Is A Bit More Complicated Than That:
If the market needs to test 143-00, next week could be a great opportunity. You can see on the chart there is enormous support in the area between 143-00 and the rising channel. The fate of the bull market will bet settled at these crossroads. Expect this area to get vibrated and the reflexivity of the MBS market to play a key role in how this gets reconciled.

Of course the stock market is playing a key role in how bond market price action is perceived. It's not negative convexity pushing yields higher, its investors selling bonds to buy stocks. This is not a time to dumb down the interplay between stocks and bonds in as simple terms of a Great Rotation. It's not that simple.

The 143-00 level on the US bond futures contract was a major key level for me that I cited in my year end A 2013 Bond Market Prognostication and it in turn provided an intense bull/bear battle that I have been documenting for much of the past three months. This level in bond futures represents approximately 2.0% on the 10-year yield and 3.25% in the long bond. We closed out the week 15bps below these levels with the 10-year at 1.85% and the 30-year at 3.10%. If the great rotation was beginning to materialize these support levels should not have held. Not only did they hold, but the withstood a barrage of selling against an intense rally in risk assets.

SOMA Bid/Cover Vs. 10-Year Yield

The demand for US Treasuries can also be seen in the waning supply sold into the Fed's QE open market bid. Coming out of the gate in January the SOMA bid/cover ratio was rising with market yields. As I implied in The Great Rotation? I thought it could have been attributable to MBS convexity selling or other one-time seasonal events such as the expiration of TAG deposit insurance. Certainly not allocation rotation as the market pundits were proclaiming. Regardless, you can see that as the 10-year hit the 2.0% level the selling into the QE bid began to ebb and has steadily been in decline for the past two months, hitting in fact one of the lowest coverage ratios last week. If money was coming out of bonds and into stocks you would not expect investors to be withdrawing supply into one of the biggest and most predictable bids in the market.
No positions in stocks mentioned.
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