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Bond Market's Memo to the Fed: This Is Not a Misunderstanding, This Is a Blow-Up


By focusing on price movement as a misinterpretation of policy, Fed officials are making it clear they don't understand there's a liquidation going on -- and this is a growing risk factor.

Last week's article Bernanke's Misfired Shot Heard 'Round the World generated a lot of attention when the FT's Izabella Kaminska referenced my market theory on the Alphaville blog. I appreciate all the comments and feedback and I am glad to see my analysis of the situation is being debated. It's not that I believe I have the answer to what is driving market volatility; I am simply trying to offer a potential scenario that the consensus (including the Fed) isn't considering. Though the fact that my hypothesis has gained traction is enough to tell me no one really knows for sure exactly what's going on.

I have been monitoring the unwinding of QE since QE III was initiated, so this chaotic behavior is all making perfect sense. On October 22 of last year in Charting a Course Balancing Open-Ended QE and the QE Asset Reflation Correlation Trade, I warned:
Most investors are looking toward 2013, 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.

On January 7 in Is US Growth Blowing Out or the QE Carry Trade Blowing Up? I was already offering a different interpretation of market price action:
So here we are at a critical juncture. Both bond yields and stocks appear to breaking out, but it is not clear what is driving the price action. Is this a product of US growth accelerating or a QE short USD carry trade that is unwinding? It's still not clear, and neither side has an edge. It will be very difficult to position for the move, likely breeding an environment of increased volatility. The market is not going to make this easy on anyone, but if you are patient, stick to your discipline, and, as I said last week, leave your bias at the door; the market should begin to provide more answers as we progress through the ensuing months.

Then, I wrote back on April 22 in Gold, Interest, an the Great USD Short Unwind:
Due to Fed policy over the past decade, market prices have been the function of a bunch of USD short carry trades that on the surface look very complex. These trades come in many forms including emerging market bonds, multinational stocks, gold, TIPS, and farm land. Whether short the dollar explicitly through leverage or implicitly through exposure, the risk is the same and very simple to analyze.

The initial reaction to the yen collapse has been an explosive rally in risk assets. As the smoke clears we are starting to witness the true macro effects of dollar strength with falling nominal yields, rising real yields, and collapsing commodity prices. This is exactly type of price action you would expect if the great short USD carry trade was unwinding, and I don't think investors currently appreciate the significance of what that means or how ugly it could get.

Despite mounting evidence that the presence of this short USD carry trade is responsible for wreaking havoc in global markets, thus far it does not appear to be appreciated by Chairman Bernanke or other Fed officials. Back on June 14 as the unraveling was gaining momentum and it was clear Fed officials were at a loss as to why bond yields were exploding higher, I proclaimed in a tweet that its not the market that doesn't get monetary policy, its monetary policy that doesn't get the market. This was perfectly evident in Bernanke's post-FOMC meeting press conference (emphasis mine):
ROBIN HARDING. Mr. Chairman, you've always argued that it's the stock of assets that the Federal Reserve holds which affects long-term interest rates. How do you reconcile that with a very sharp rise in real interest rates that we've seen in recent weeks? And do you think the market is correctly interpreting what you think is most likely to be the future path of the Federal Reserve's stock of assets?

CHAIRMAN BERNANKE. Well, we were a little puzzled by that. It was bigger than can be explained I think by changes in the ultimate stock of asset purchases within reasonable ranges. So I think we have to conclude that there are other factors at work as well, including, again, some optimism about the economy, maybe some uncertainty arising. So, I'm agreeing with you that it seems larger than can be explained by a changing view of monetary policy.

It's difficult to judge whether the markets are in sync or not. Generally speaking though, I think that what I've seen from analysts and market participants is not wildly different from what, you know, the Committee is thinking and trying to-as I try today to communicate.

God help us… Real rates are rising because QE has failed to stimulate aggregate demand. The short USD carry trade was predicated on the Fed's negative real rate regime, and that rates are rising is the single most important catalyst behind the unwind.

The June FOMC post mortem has been a pathetic attempt to talk down market rates since its obvious participants don't misunderstand the Fed's policy actions. Last week Fed speakers including Dudley, Williams, Stein, Fisher and Powell all hit the tape with the exact same message: This is just a big misunderstanding. This is just a misinterpretation of policy. Well glad that's all cleared up.
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